It's generally thought that the starting point for investment decisions should be our appetite for risk, as this determines how much we put into risky assets. However, a new paper challenges this. It suggests that the starting point is not so much risk appetite as our financial well-being, or our contentment with our wealth.
This well-being, says Rachel Pownall of Maastricht University, is closely correlated with appetite for risk. People whose wealth is below their aspirations are more likely to take risks than those who are more content with their wealth.
And the correlation between financial well-being and actual wealth, while positive, is not strong. Many objectively rich people have low financial well-being. Their efforts to close the gap between reality and aspiration leads them to take risks, such as holding lots of equities, taking on high debt, buying esoteric assets in the hope of stellar returns, or even risking going to prison for insider dealing.
This is not to say that all differences in risk appetite are really differences in financial well-being. A study of twins in Sweden found that around a quarter of the variation in people's risk appetite has a genetic basis. But this leaves three-quarters with another basis, which includes financial well-being.
This matters. Regarding financial well-being rather than risk aversion as the starting point for thinking about investment decisions has two implications.
First, it creates a role for character planning rather than financial planning. Low financial well-being exists when there's a gap between what we have and what we want. There are two ways of closing this gap. One is to increase what we have, which might involve taking reckless gambles. The other way is to reduce what we want, by acquiring cheap tastes and habits. What's the point of having a fast car when you'll only be caught speeding? Why own a big house when you can only sleep in one bed at a time? And so on.
Of course, acquiring cheap tastes flies in the face of two powerful forces: the vested interests that want us to buy risky assets and expensive goods; and our culture of narcissism which says 'you can't change who I am'. But this doesn't make it a bad idea.
A second implication is pointed out by some economists at the University of Technology in Sydney. Financial well-being can explain why share and house prices are so volatile.
Let's start from the premise that people compare their wealth to others – they want to keep up with the Joneses. And let's say house prices rise. The Joneses will then enjoy a rise in their wealth and spend more. Those who didn't own a house, or owned a smaller one, will then suffer a fall in financial well-being as they've slipped behind the Joneses. To catch up, they might take on a big mortgage to buy a bigger house. This buying will amplify the first rise in house prices, causing price moves to feed on themselves, leading to prices rising too far. A similar thing can happen sometimes with share prices.
One important feature of bubbles, such as the tech bubble of 1999-00 or the housing bubble of the mid-2000s, is that some people buy bubbly assets not out of hope but rather out of fear – the fear of missing out or falling behind. Such behaviour makes no sense from the point of view of conventional economics which thinks of risk and expected return. But it is perfectly comprehensible from the perspective of keeping up with the Joneses.
In this sense, the tired old cliché that markets are driven by greed and fear is only partly true. They can be driven by envy too.
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Chris blogs at http://stumblingandmumbling.typepad.com