Most investors have a natural and healthy aversion to risk. It’s what keeps them from betting the ranch on things like Bitcoins or multilevel marketing schemes. But too much aversion to risk can be as bad – or even worse – than not enough.
According to the latest figures from the Federal Reserve, the average U. S. investor has more than 50% of her investment money sitting in cash. That is way too much, and it’s costing these investors dearly. The rule of thumb used by financial planners is that every dollar kept in cash will cost an investor $1.50 in foregone profits over a 20 year time horizon when compared to investing that same dollar in the stock market.
Anyone who has an investment time frame of 10 years or longer should not have more than 20% of their assets in cash. So why have investors become so cautious when the stock market is trading at an all-time high? The Economist magazine had a few things to say about how different people perceive risk in very different ways.
Risk has always had an image problem. It is associated in the popular mind with gamblers, skydivers and, more recently, the overpaid bankers who crippled the global economy. Yet long-term economic growth would be impossible without people willing to wager all they have by starting a business, expanding an existing one or trying to invent a better mousetrap.
Though changing appetites for risk are central to booms and busts, economists have found it hard to explain their determinants. Instead, they tend to cite John Maynard Keynes’s catchy but uncrunchy talk of “animal spirits”. Recent advances in behavioral economics, however, are changing that.
Economists have long known that people are risk-averse: Daniel Bernoulli, a Swiss mathematician, observed as much in the 18th century. Consider this simple test: given the choice, would you prefer a gift of $50, or to play a game with a 50% chance of winning $120? It might seem logical to pick the second, since the average pay-off—$60—is bigger. In practice, most people choose the first, preferring a small but certain payment to a larger but uncertain one.
Yet the willingness to run risks varies enormously among individuals and over time. At least some of this variation is inherited. One study of twins in Sweden found that identical ones had a closer propensity to invest in shares than fraternal ones, implying that genetics explains a third of the difference in risk-taking.
Upbringing, environment and experience also play a part. Research consistently finds, for example, that the educated and the rich are more daring financially. So are men, but apparently not for genetic reasons. Alison Booth of Australian National University and Patrick Nolen of the University of Essex found that teenage girls at single-sex schools were less risk-averse than those at co-ed schools, which they think may be due to the absence of “culturally driven norms and beliefs about the appropriate mode of female behaviour”.
People’s financial history has a strong impact on their taste for risk. Looking at surveys of American household finances from 1960 to 2007, Ulrike Malmendier of the University of California at Berkeley and Stefan Nagel, now at the University of Michigan, found that people who experienced high returns on the stockmarket earlier in life were, years later, likelier to report a higher tolerance for risk, to own shares and to invest a bigger slice of their assets in shares.
But exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses. That is the conclusion of a paper by Samuli Knüpfer of London Business School and two co-authors. In the early 1990s a severe recession caused Finland’s GDP to sink by 10% and unemployment to soar from 3% to 16%. Using detailed data on tax, unemployment and military conscription, the authors were able to analyse the investment choices of those affected by Finland’s “Great Depression”. Controlling for age, education, gender and marital status, they found that those in occupations, industries and regions hit harder by unemployment were less likely to own stocks a decade later. Individuals’ personal misfortunes, however, could explain at most half of the variation in stock ownership, the authors reckon. They attribute the remainder to “changes in beliefs and preferences” that are not easily measured.
This seems consistent with a growing body of research that links a low tolerance of risk to past emotional trauma. Studies have found, for example, that natural disasters such as the tsunami that hit South-East Asia in 2004 and military conflicts such as the Korean war can render their victims more cautious for years.
The same seems to be true for financial trauma. Luigi Guiso of the Einaudi Institute for Economics and Finance and two co-authors examined the investments of several hundred clients of a large Italian bank in 2007 and again in 2009 (ie, before and after the plunge in global stockmarkets). The authors also asked the clients about their attitudes towards risk and got them to play a game in which they could either pocket a small but guaranteed prize or gamble on winning a bigger one. Risk aversion, by these measures, rose sharply after the crash, even among investors who had suffered no losses in the stockmarket. The reaction to the financial crisis, the authors conclude, looked less like a proportionate response to the losses suffered and “more like old-fashioned ‘panic’.”
These studies suggest that the sweep and severity of the recent slumps in America and Europe will scar a wide range of people, not just those who lost money in the markets. The financial crisis is likely to inhibit them from taking the sort of risks that help propel the economy for decades to to come. Regulators and policymakers may soon be worrying about the lack of risk-takers, not fretting about their excesses.