You’re not as tolerant for risk as you think

Do you feel lucky?

A few years ago, Federal Trade Commission economist Patrick McAlvanah sought to understand how the opposite sex influences our tolerance of risk. It was already well known how other spheres of decision-making were influenced: Seeing attractive photos of a woman makes men more impatient, for example.

As he was studying at Washington University in St. Louis at the time, McAlvanah recruited 241 college students (121 were male), and had them take a survey on computers to measure their risk tolerance.

A typical question went something like this:

Which would you prefer?
A: $2,000 for sure
B: A 75% chance of $4,000

If the subject chose the “riskier” choice, the computer would ask a similar question in which the guaranteed reward increased, and so on, until the professor found at what point the student switched to the guarantee.

After that part of the survey, the men and women were shown attractive pictures of the opposite sex (as rated by hotornot.com) and were asked to rate them in attractiveness from 1 to 10. Another group saw pictures of cars from “ratecarpics.com”.

After viewing the “hot” photos of people or cars, he assessed their risk tolerance again. The people who viewed cars didn’t significantly change their risk preferences, but the people who saw hot men or women saw a big change.

The average subject who was indifferent to a choice between a guaranteed $4,560 and a 50% chance of $12,000 was now indifferent between $4,908 and the same gamble. So in other words, if you offer a guy a bet one minute and he turns you down, you might be able to change his mind simply by letting him look at pictures of hot women.

Maybe before assessing their clients risk tolerance, financial advisors should ask what magazines they were looking at in the waiting room?

Our “risk tolerance” changes all the time.

We use “risk tolerance” to mean both how much volatility you can take given your age (older people need less money in stocks, etc.) and how strong the lining of your stomach is when you see your portfolio bounce around. For the purposes of this post, we’re going to be talking about the stomach lining.

So have you ever thought “I could do that”, after watching some sort of incredible feat of bravery? You know, someone runs into a burning building to save a two-year old—those kinds of things. The thing is, you don’t know how your body and brain is going to react when actually faced with the intense heat and adrenalin that comes with such an intense experience.

When you read about it in the newspaper, you’re thinking, “Throw a fire resistent blanket over my body, stay low, be the hero.” When you face the fire, I imagine you’re thinking “…” as hormones you didn’t even know you had wash over your body.

To a much lesser extent, that’s kind of what it’s like to try to ascertain your emotional risk tolerance before actually being faced with a market crash. But unfortunately, it’s exactly what many financial advisors ask you to do before they allocate your portfolio.

A typical question will go something like: “If the stock market dropped by 20%, what would you do?”

A. Nothing
B. Sell stocks.
C. Buy more stocks.

All else being equal, the “right” answer, if we’re “rational” investors, is to buy more. Stocks are even cheaper than they were the day before. Grab a hold of some while they’re on sale.

So, when a lot of people fill out these forms (myself included) we end up looking like the Evel Knievels of investing. We’ll stick to our investing plan no matter what. As in the case of the fire, you never know how you’ll actually act until you’re faced with the situation.

So what’s the solution?

I’m not so sure risk tolerance can actually be measured before the fact. But a bunch of researchers have put their heads together and tried to come up with something at least a little bit better than the quick questionnaire you’ll typically see.

One of these, designed by FinaMetrica.com, has been pretty well-reviewed in the personal finance press.

What makes it different? Well, it’s longer, for one—you’ll be answering 25 questions in about 30 minutes, as opposed to the little 5 question, 5 minute questionnaires you typically see. The questions have also been tested to see how predictive they are of the testers’ actual risk tolerance. Some questions that you might have thought can predict actual risk tolerance actually have no bearing at all.

Anyway, the final difference is that it costs $45. It seems that every time they get a press mention, they offer it to readers for free for a little while. I’ll keep a lookout and post a link next time I see it offered.

A cheaper solution: Capture yourself when you’re actually facing a market crash, write down how you feel on a piece of paper, and stick it in an envelope. This might even still work now, even though the market is 77% or so off its low. People are still feeling pretty crummy about stocks in general, and money is still flowing into bond funds.

In a few months, if things still keep going well for equities, I’d expect to see that trend reverse. And by then, it’s going to be too late to remember how big a tolerance for risk you have.

Or, take the decision-making out of your hands altogether, either by utilizing a financial advisor who’s an emotional buffer between you and your money, or by making your allocation decision once and never touching it again (such as through a target-date retirement fund).

Yeah, there are problems both with advisor fees and with target-date fund allocations, but those costs are lower than the costs of continually riding waves of panic and exuberance.

Tagged as: behavioral finance, Investing, risk