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Perception, Reality, and the Psychology of Risk

My kid’s favorite TV show is Mythbusters. The host, Adam Savage, is known for saying, “I reject your reality and substitute my own.” He often says this in jest, but he is actually describing the human condition, especially when it comes to money.

When it comes to investments, your perception is your reality, regardless of what the facts suggest. Perceived risk is the risk you believe exists in an investment, whether or not that degree of risk really exists.

Just over two years ago the stock market bottomed from its terrifying 54% drop and began a similarly spectacular recovery. The week the market hit the bottom, I received a barrage of calls, mostly from clients scared to death and wanting to sell. I was able to convince most of them either not to sell or to just reduce the amount of stocks in their portfolios.

Ironically, I also received a couple of calls from clients who were similarly panicked, wanting to put money into the market as quickly as possible. One told me, “This is the opportunity of a lifetime!”

As it turns out, those who wanted to invest and those who did nothing were correctly perceiving reality. Those who sold failed to distinguish fact from their perception.

In an article, “The Psychology of Risk,” Professor Victor Ricciardi of the University of Kentucky explains that people focus on different components of the same situation. He says, “A person’s behavior is based on their perception of what reality is, not necessarily on reality itself.”

Ironically, this aspect of human nature is the opposite of the way economists think humans react financially. According to Ricciardi, economists base economic theory on four premises:
• Investors make rational (optimal) decisions.
• Investors’ objectives are entirely financial in nature, in which they are assumed to maximize wealth.
• Individuals are unbiased in their expectations regarding the future.
• Individuals act in their own best interests.

This may be the way classical economists perceive human nature, but it certainly isn’t reality. Had the fathers of economic theory spent a week in my office, they would have quickly concluded their four premises were unrealistic.

Fortunately, a new breed of economists and psychologists are suggesting that emotions have everything to do with economics and how people make financial decisions. This emerging field is “behavioral finance,” which asserts people are sometimes fully or partially irrational and inconsistent in making their investment decisions.

My experience is that emotions can greatly interfere with self-control, which is vital in making rational financial decisions. Very few people understand the physiology or structure of their brains and have the ability to recognize when the emotional brain (limbic system) has disconnected from the thinking brain (cerebral cortex).

Making rational decisions is no small task. Not only must we be able to process our own emotional impulses, we must also have the knowledge and imagination to anticipate consequences.

During a stock market decline, those who sell out focus on the relief from anxiety that getting out of the market may bring. Those who stay in or increase their investments may have the same initial thought. Yet they override that message by first using their left brain to access the knowledge that market cycles happen and recovery is as normal as decline. Next they switch to the right brain to help them imagine the anxiety that would come with missing out on gains when the market does recover.

Rational financial decisions are not based on ignoring emotional impulses, but on understanding and managing them. Ironically, understanding that we make financial decisions irrationally is a good first step toward learning to make them rationally.

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One Response to Perception, Reality, and the Psychology of Risk

  1. Dan Schweihs May 2, 2011 at 9:38 am #

    There is one area that Uncle Sam does believe in emotions in financial decisions. That is “skin in the game” in both residential and commercial lending.
    Every economic textbook ever written believes in marginal decision making. That “sunk costs are sunk.” A rational decision maker looks at the world today and makes decisions at the margin.
    Money spent on a downpayment is a sunk cost. VA and USDA loan programs are 100% loans without down payments and have lower foreclosure rates that FHA loans. Yet politicians continue to talk about improving FHA loan performance by increasing down payments because if a borrower has made a down payment, they will have an emotional commitment to keep the house. Even though sometimes the best cold, rational decision when a borrower gets a financial curve ball in life would be for that borrower to throw the keys in the bushes, file a Chapter 7 Bankruptcy and rent for a few years.
    Uncle Sam is consistently telling first time homeowners to use their rainy day fund as a down payment. And then wondering why the have trouble when it rains. Uncle Sam is clearly suggesting that borrowers make emotional, not rational decisions. And look at the housing industry today. How’s that working out for you, Uncle?