The Color of Risk Tolerance and Perception
During periods of market volatility like we’ve seen lately, it’s important for investors to understand their risk tolerance and perceptions about risk.
Even savvy investors begin to set aside their previous understanding of investing principles and make rash decisions during a volatile market. This is where your relationship with a professional financial advisor can really help you stay on track.
Think of the brain as running somewhere between cool blue and red hot. When the market is relatively stable, the brain generally resides in a cool, relaxed state. When the market is volatile, the brain elevates to a hot, scared or even angry state. Hot states make it difficult for investors to keep from inflating possible risk and danger.
Your tolerance for risk stems from your attitudes about risk taking. The good news is that risk tolerance can be measured by studying a person’s willingness to take financial risks or engage in risky financial behavior. Risk tolerance can even be quantified by a number which can help your financial advisor better determine your tolerance for risk in your portfolio.
Influences on Risky Behavior
Internal characteristics like heuristics and biases can directly affect your response to market volatility. Heuristics are approaches learned for problem-solving and self-discovery that are sufficient for reaching an immediate goal. Biases enable investors to misperceive the frequency and magnitude of risk (Paek & Hove, 2017). There are a number of biases that can negatively affect an investor’s perception of risk and impact best intentions. Key influencers include:
Media Influence – Public awareness by the media can influence an investor’s perceptions depending upon the amount of coverage, how the message is framed, tone of the message, trustworthiness of media sources, format in which information is presented and source channels (Paek & Hove, 2017).
Availability heuristic – Heuristics suggest that when people are aware of risks, they make assumptions that those risks occur more frequently than is reality.
Affect heuristic – Relying upon current emotions to make decisions about risk.
An investor’s perception of risk can be colored by a multitude of factors. There are cognitive elements which are made up of one’s knowledge and understanding of risk, coupled with emotional elements running the gamut of how investors feel about risk.
Measurement of risk perceptions have been hotly debated through the years by financial advisors, industry regulators and researchers alike. Several models have been proposed by researchers Paek & Hove (2017) which might help investors understand how they process information and make decisions:
Risk perception model – People generally accept risk that is viewed as involuntary
Mental noise model– Mental noise that comes from stress, disaster, uncertainty, dread, vulnerability and familiarity reduces an investor’s ability to make decisions
Negative dominance model – States that negative situations that produce anxiety and fear are more likely to create an environment for hyper-focusing on negative messages
Trust determination model – This is where an investor’s perceived trust of managers comes into play in their reaction to risk.
A Closer Look at Risk
There is a difference between our general tolerance for and perception of risk. To measure these differences, researcher Paul Slovic used “cognitive maps” to sort through risk attitudes and risk perceptions (1987).
Research shows that humans form an optimum balance between risk and any benefit that might be associated with it. Unfortunately, they do this by using social and cultural factors which can lead to inconsistent evaluations of risk. To understand the color of risk in an investor’s mind, we need to take a closer look:
Voluntary and Involuntary Risk – Slovic’s research found that when weighing an activity, people generally accept greater voluntary risk. That’s why an activity such as rock climbing is often viewed as having less risk than the involuntary risk from drinking fluoridated water (1987).
Informed Risk – What’s more, when people are informed of a risk, they may read between the lines, generalize, hold hidden agendas, or even invent biases and heuristics. What’s more, people generally perceive risk levels in the current moment as higher. This explains why current topics like genetically modified food reside on the hot side of people’s emotions and cleaning ears with a cotton swab reside on the cool side, despite the cotton swab posing a far greater risk to injury.
Your Financial Advisor Can Help
So, what are investors to do to combat the rollercoaster of emotions that run between hot and cold when it comes to risk? There are several things that can help set apart successful investors from average investors:
- Find the best possible managers to work with who understand people’s tolerance and perceptions of risk
- Actively help plan a portfolio that protects and grows for the future
- Routinely review and monitor portfolio strategies
- Organize your financial life and view it on a map that shows where you are in meeting your goals
- Use an online risk assessment tool that helps you understand your tolerance for risk
- Download a financial planning app to help you keep track of your portfolio, real-time
- Begin a “news diet” and dial down the television, radio and online news for a while
A good manager knows that simply informing people of risk is not enough. Your financial advisor should understand and legitimize your concerns about risk and help you place it in perspective.
Paek, H., & Hove, T. (2017, March 29). Risk Perceptions and Risk Characteristics. Oxford Research Encyclopedia of Communication. Retrieved from https://web.archive.org/web/20201023094824/https://oxfordre.com/communication/view/10.1093/acrefore/9780190228613.001.0001/acrefore-9780190228613-e-283.
Slovic, P. (1987). Perception of risk. Science, 236(4799), 280-285. doi:10.1126/science.3563507
Kris Maksimovich is a financial advisor located at Global Wealth Advisors 4400 State Hwy 121, Ste. 200, Lewisville, TX 75056. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at (972) 930-1238 or at email@example.com.
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