Defining risk is a risky business. For starters, there’s a mismatch between the financial industry and regular folks. Investment professionals think of risk in technical terms, like standard deviation or price volatility, whereas the rest of us see it more simply as the possibility of losing our money.
Often there’s a reality gap when it comes to understanding our personal tolerance for financial risk. That’s because our capacity for risk is affected by not only our financial position, but also, and perhaps more importantly, by our psychological make-up. One person may have the financial means to take on risk but not the emotional mettle, while another may have a keen appetite for risk but lack the financial stamina to truly handle it. Often when people say that they have a “high tolerance for risk”, what they really mean is they have a high tolerance for outsize financial gains! Their optimism is often sorely tested during a market downturn.
What contributes to our individual risk preferences? It’s a mix of factors. Researchers have uncovered a genetic component. Also, certain personality traits, such as openness to new experiences, tend to make people more risk-seeking. Early formative experiences, like growing up during The Great Depression or the global recession in 2008, shape our worldview of financial risk. Between the ages of 16 and 25, we are forming our beliefs about the world. A high-stress experience in this period often has effects on our personal and financial choices for decades to come.
A growing number of studies have identified another key driver of our risk appetite: environment. Who we live and work with, where we live, and how social we are can predict around 25 per cent of our investment choices – far more than factors conventionally associated with risk tolerance, such level of financial knowledge, gender, occupation, income, net worth, and age.
Scientists call it “emotional contagion” but it’s more commonly referred to as “word-of-mouth”—and it’s a powerful determinant of how we make decisions. The stronger our community ties and the more social we are, the stronger its effect on us. A 2014 study found that people living in the same household were 2.5 times more likely to hold the exact same investments as the general population. Coworkers were 1.4 times more likely to do the same.
The researchers found that those living in the same postal codes also shared similar investing choices, and investors were more likely to buy stocks in a particular industry if others living within a 50-mile radius bought in. And, when one person in the household or at work switched investment funds, others were more likely to do so as well. Buzz of high returns from a particular investment is like catnip to both professional and amateur investors, with both groups being more likely to buy a stock based after discussing it with a friend.
Location, location, location
Not surprisingly, people who live in countries with a high degree of social connectedness and political stability, such as Switzerland and Scandinavian countries, opt for long-term investments compared to those living in more politically volatile regions such as Russia, Romania, and Greece, who gravitate to more speculative assets that come with the potential for quick returns.
A 2018 U.S. study that reviewed the trading patterns of nearly 500,000 people found that investors in New York and Nebraska were willing to take the most financial risk compared to those living in New Jersey, Florida, New Mexico, Arkansas, and West Virginia, who had the lowest risk appetites.
Whether we see an event as risky or not depends to some degree on its context and its magnitude. For example, most people would gracefully accept losing 50 cents gambling a loonie, but react very poorly to losing $50,000 on a $100,000 investment, even though they both represent a 50 per cent loss. After a sharp market decline, even the potential of incurring a small loss can create stress and extreme risk avoidance because of the negative context, whereas a similarly small decline during an otherwise rapidly rising market is usually taken in stride.
One way to better understand our true risk preferences is to keep a journal of our buying and selling decisions including our reasons for doing so and how we responded to changing market conditions. Humans are social creatures and we are influenced by our peers, family, and neighbors, not to mention the daily firehose of financial and social media content. By gaining insight into our past decisions and their outcomes, we’re less likely to be unconsciously influenced by our environment to the same degree.
Rita Silvan, CIM™️, is personal finance and investment writer and editor. She is the former editor-in-chief of ELLE Canada magazine and is an award-winning journalist and tv media personality. Rita is the editor-in-chief of Golden Girl Finance, an online magazine focusing on women’s financial success. When not writing about all things financial, Rita explores Toronto’s parks with her standard poodle.
Rita Silvan is a paid spokesperson of Sonnet Insurance.