Behavioural finance and risk tolerance

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Misjudging your risk tolerance can be devastating.
Misjudging your risk tolerance can be devastating.

This week’s column will continue the discussion on behavioural finance. Specifically, how individual investors overestimate their ability to assume risk.

Another way of introducing the topic is suggesting human ego interferes with logical decision-making processes.

Financial theory suggests investors are rational and they collect and analyze information in an unbiased logical way. Apparently this is far from the reality of how decisions are made.

The problem with humans is we tend to vastly overstate our abilities. Behavioural research provides some interesting examples.

Adult men were asked three questions relating to their abilities.

All men answered they were in the top quartile with respect to their ability to interact with others. Surprisingly one quarter said they were in the top 1%. The question of leadership ability had 70% of men responding they were in the top quartile. As for their athletic ability, 60% rated themselves as top quartile athletes.

Reality check: everyone being ‘above average’ is statistically impossible.

However, it seems the male ego is alive and well and resides in most men in our country.

Research shows that there are several psychological processes that combine to generate flawed self-assessments, but they are beyond the scope of this column. The question we need to be concerned with is how do we use this information to better understand the investing process?

Many advisors ask their clients to complete questionnaires that, in part, are meant to understand their ability to assume investment risk. That is a significant issue because investing is all about accepting a level of risk.

For example, if a new client overrated his ability to assume investment risk, the recommended portfolio might include a high percent of investments in stocks. Individual stocks or stocks held within a mutual fund.

If the stock market declined significantly, would the investor suddenly realize that he is outside of his comfort zone and therefore sell all of his stocks at a significant loss?

Investing in stocks means you invest for both the good times and the bad times. If you are not comfortable with a higher level of investment risk, then it is not suitable that you invest a high percent of your portfolio in stocks.

Misjudging your risk tolerance can be devastating. Overestimating it and then panicking and selling investments at the first sign of trouble is a common mistake that costs individual investors billions of dollars.

Some might refer to selling in a panic as undisciplined investing. The truth might be that without an initial acceptable risk tolerance, the investment should not have been made in the first place.

Either way it is a very costly mistake and it happens far too often.

Next week, my final thoughts in this three column series on behavioural finance will look at the lack of logic many investors have when evaluating their various investments.

The overall theme of these three columns is to understand the realities of human behaviour and how they conflict with your investment objectives; which are to act logically and achieve acceptable long-term returns.

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