Behavioral Finance 101 - Risk Perception

Consider this bet: heads get 25 euros, tails lose 20 euros. Would you accept? What if you were winning 100 euros during the course of the bets? Would you give up, thus “closing” the gains? Would you continue because you are on a “lucky streak”? What if you were losing those 100 euros? Would it change your view on a new bet? Would you accept a double or nothing bet to try and recoup your losses?

Neither the risk nor the return on bets is altered by the current situation of the bettor. It is, however, practically impossible that this situation does not have an emotional impact and influence our future decisions, as it alters our emotional state and perception of risk and return.

This change can be seen in several investor behaviors. We often come across investors who are willing to accept more risk if they are in a winning situation either because they are "playing with casino money" or simply because those winnings act like a "cushion", making potential losses harder to reach the capital initially invested.

Another situation that we can occasionally observe is the investor who gets “hooked” on losing positions.

What I intend to convey is that risk aversion is not a constant over time. For the same investor, it may change depending on the gains (or losses) of the recent past, leading him to accept more (or less) risk without anything, except the investor's emotional/psychological state, having changed.

The recent past tends to have a greater impact than the distant past on an investor's emotional state, but emotionally significant situations also have that influence, regardless of whether they are in the distant past.

The impact that 1929 had on a generation of investors was quite significant and, more recently, the 2008 crisis made many investors more cautious and even suspicious of the capital markets, not enjoying the phenomenal returns of the stock market in the last 10/11 years.

I think, and without wanting to repeat myself in several articles, that the best way to avoid this kind of bias and emotional decisions is to plan and create hypothetical and possible scenarios during our investment period.

What are you going to do next time the stock market drops 30%?

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