Behavioral finance FAQ / Glossary (Risk attitude)

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Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

Risk (-taking) attitude / appetite 
   / preference / profile


08/ 11i + see attitude, risk, risk
aversion, risk tolerance,
style of

investing, profiling (of investors),
risk premium, (expected) utility

Safety first? Or ready for the thrill?

Definition: an investor's risk attitude, (or risk appetite / preference
/ profile), is its degree of risk aversion (or, conversely, risk acceptance /
tolerance) when making decisions.

There is a gradation in this risk-taking attitude

1) Risk averse

2) Risk neutral (risk tolerant)

3) Risk seeker (risk taker).

(see below the related articles).

Those attitudes can be found in all risk situations, which includes of course those
of financial risk.

Highly variable taste for risk

Different taste buds for different risk soups.

The degree of financial risk appetite / acceptance varies:

Between individuals (everyone has its own risk
   profile)

Various questionnaires and psychological tests were devised and
are supposed to give an idea of the risk profile of an individual
or a population.

Also there is some relation with the level of dopamine in the
brain which incites to take decisions, actions, risks.
Please, come to the lab. ;-)


Also between social segments (categories of people):

genders, types of occupations, groups, countries.


Between personal activities:

A person can be a risk seeker in sports and risk averse in managing
his money.


Between external situations:

Usually people take more risk in those that involve competition.

Obviously, also the higher the expected reward, the higher the
accepted risk.

But there is no pure proportionality between those two values,
because of various phenomena seen in this (obviously precious and
helpful ;-)) glossary:

Expected utility, risk premium, loss aversion, the prospect 
theory,and many other cognitive and emotional traits.


In time: the risk attitude can be unstable.

Periods of euphoria's or gloom tend to alternate, not only for
individuals but also for collective attitudes.

Risk aversion / averse


00/6i,12i - 01/8i - 02/1i,9i,12i
- 03/3i,4i - 04/2i,5i
- 07/5i,8i
- 09/1d + see risk attitude, risk
premium, fear, loss aversion

Carrot and stick.

In average, people are risk averse. Usually they are not too ready to

take risks unless given extra incentives,...which range from
carrot to stick.


When thus attitude is related to economic / financial risk, it means that they
will take a risk only in exchange for some compensation in good money.

More precisely, if they accept to invest in an asset on which they
feara sizeable money loss
if things turn bad:

They want an extra "expected return" (*) to
  
overcome their fear.

 (*) An expected return (see expectancy) is a mathematical

    projection that already averages out the
    probabilities of gains and losses.
    But the risk averse player asks for more than that.


Therefore, they buy it only if it is at a lower price than a safe
   asset (**).

(**) This is plain math also:

=> the lower the price (P) paid for an asset that gives an
      income (I),

=> the higher is the return (R = I/P) for its holder

That is how risk aversion has an incidence on market prices:
     see risk premium, utility.

Variations between people and periods

Risk taker today, risk averse tomorrow....

Although most investors most of the time are risk averse,

the degree of risk aversion is an individual trait that differs from one
investor to another.

A relation usually cited is that the less wealth and income
   an investor
has, the more he is supposed to avoid risk in his
    decisions.

This is because a loss would be fatal for people without financial
reserve...


But risk aversion is not linked only to such rational elements, it has
  emotional components
and can easily become a bias.

Such "sentiments" can change 
from one period to another (preference reversal).

See optimism, risk attitude...

The individual level of risk aversion, and its average
level for all investors, are therefore unstable


Also in chaotic periods, people realize that there is pure

   uncertainty, thus not just a known and measurable (*) "risk",
   (*) theoretically
via probabilities

hen that uncertainty gets widely perceived, market volatility usually
rises and prices tumble, as people are more uncertainty averse
than risk adverse.

What about loss aversion?

When the bet failed.

Risk aversion should not be confused with loss aversion (see that
phrase), although academics tend now to think that risk aversion is just a
specific case of loss aversion.

The "prospect theory" (*) privileges loss aversion as the broader (and less
rational,as not fully related to risk)
concept to understand how people
decide when facing risky situations.

(*) It states (see the related article) that people attribute to the same
    
amount of money, more value when they lose it than when they
     gain it.


Actually, when the market price is under what is called their reference price
(see anchoring), people are usually more loss adverse than risk adverse.

They prefer the risk to go on betting on the horse than to accept to limit the
damages this cumbersome pet already made them lose.

See in the general "Aversion" article the relations
between
risk aversion, prospect theory, loss aversion,
regret aversion, disposition effect...

 

Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

Risk aversion

See specific page

Risk neutral

see risk tolerant

Risk perception, perceived risk

See specific page

Risk seeker, seeking

See risk tolerant

 

Risk tolerance, tolerant


02/7i - 03/12i - 08/11i (risk
taking) + see risk attitude,
optimism, overconfidence

Cool people. And thrill seekers.

Some people are not risk averse, but risk neutral / risk tolerant (or
unconscious of risks / indifferent to it).

Some others are even risk seekers / risk takers,

Either all the time, or in some "exuberant" circumstances,

And either because of optimism, overconfidence, or for the thrill, ...if not
   for suicidal reasons.

Even if blind risk-taking might be quite destructive, it is a luck that
some people have a bias / appetite for risky moves,

If there was no taste for risk taking, initiatives,
innovations, entrepreneurship and even active
and opportune reactions to problems would be
inexistent.

=> Mankind would be stagnant or regressing.
      And boring, too!

The "precautionary principle" might sometimes be the
wrong ...precaution.

It could express a status quo bias (see that phrase) and thwart
active adaptations to evolutions and challenges.

Incidences in finance and business

In some market situations, in which greed is strong,
most investors might become more risk tolerant / risk seeker.

Also, it seems that some firms, even financial firms, are unconsciously tolerant,
as they have no real risk policy that defines what are their risks and how far
they are ready to accept them.

 

(Related topics)

(Small risk) attitude / aversion

See rare events

Risk (vs. uncertainty)

See specific page

Risk premium, risk premia puzzle

See specific page

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

Members of the Behavioral Finance Group,
please vote on the glossary quality at
BF polls

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This page last update: 10/08/15  

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