What determines your attitude to risk? Of course, we like to think that it depends upon a rational assessment of the outlook for companies and markets. New research, however, shows that this is only part of the story. Chris Brooks and Louis Williams show that our personalities also shape our willingness to take risk.
In a study of over 600 UK investors, they show that extroverts tend to take more risk than introverts. This corroborates research by economists at the University of Sheffield, who have found that people who spend more time with friends or at sports clubs or churches are more likely to own equities than others. This could be because an active social life gives us comfort in hard times and hence more ability to cope with losses: Professors Brooks and Williams also show that mental resilience is associated with greater risk-taking.
What doesn’t help us take risk, though, is conscientiousness. Conscientious investors tend to overthink risky situations, which makes them less able to cope with them.
Again, this fits with previous findings. Economists at the University of Western Australia have found that conscientious investors actually earn lower returns than others. One reason for this is that their commitment to hard work can cause them to trade too much. They are also more likely to regard losses as being due to personal failure rather than accidents – which causes them to hold onto losing stocks rather than admit their failures and dump them.
You might find this surprising. Surely, conscientiousness makes us spend more time researching shares which can only be good.
Not necessarily. It’s easy to spend hours merely finding information that is already in the price. Investors who do this get no benefit from their hard work but are prone to the downsides of conscientiousness.
Professors Brooks and Williams also find that people who tend to get angry quickly “are prone to make rash and self-defeating decisions” as investors. They also find that cheerful people are more willing to take risk – which helps explain the longstanding fact that equities usually rise in the spring as brighter evenings improve our mood and fall in the autumn as the nights draw in.
You might think all this is obvious. But it’s not. It’s a challenge to conventional economics which regards tastes as simply exogenous. Such a view isn’t wholly unreasonable as the chances of the market rising are the same for all of us, whether we’re lazy or hard-working, miserable or cheerful. But it is only part of the story.
Our personality traits, however, are not the only thing that causes us to regard the same objective risks in different ways. Columbia University’s Michael Woodford has pointed out another – how we translate likely losses and gains into our mood.
Faced with the chance of (say) a £50,000 loss, we naturally ask how we would feel in such an event. For some of us, it might mean having to work longer or sacrificing our dream home. For others, though, it might mean leaving a smaller bequest or merely having a smaller cushion of wealth. Such differences of interpretation mean otherwise similar people will have different attitudes to the same risk.
This perspective explains a lot, for example why we both gamble and buy insurance: it’s because our house burning down is a completely different thing from losing a few pounds in a casino. It also explains why people play the lottery or buy speculative stocks even though both offer poor objective prospects. The small chance of a life-changing sum of money has more emotional value than a bigger chance of smaller gains, even if the expected monetary value of the latter is bigger.
There’s something else, pointed out by Yale University’s Shane Frederick. He shows that people who do well on cognitive reflection tests – which measure our ability to override our instincts – tend to take more risks. This could be because they are better than others at translating likely gains and losses into mental states and so regard gambles as being less uncertain.
Which matters. The ability to stop and think is one that can be learned and developed, just like other means of improving our ability to deal with risk such as the ability to control our emotions.
And there’s the point. Our taste for risk isn’t wholly fixed. It can be changed. It can be changed in dangerous ways by peer pressure, the fear of missing out, our tendency to act upon impulse or even the time of year. But it can also be improved by education, emotional regulation and reflection: we shouldn’t, for example, trade when we are unusually angry, sad or happy. We can also, says Professor Brooks, become better investors if we learn mental resilience.
We must therefore always ask: why am I willing to take on this risk? or: why am I so worried? We must reflect more upon how we think about risk. Doing so requires that we abandon the illusion that it is merely a matter of gathering objective facts about the economy and companies. We need to know ourselves as well as the economy.
