Behavioral finance FAQ / Glossary (Risk perception)

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

Perceived risk, risk perception

03/10i - 06/11i - 10/5i
+ see perception, risk

When risk is a matter of taste.

Risk perception is a subjective appraisal of risk .

Often, the perceived risk

can be the opposite of the real risk,

or can differ widely from it by underestimating or overestimating it.

or is fully illusive in cases of uncertainty (see that word), in which
    the risk cannot be really known.
    The risk can then be overstated or, on the contrary,
     are invented to create pseudo certainties that avoid the anguish.

How such misperception happen?

Although this biased understanding might be more widespread among
people in the street than among specialists, it is not an absolute and
general rule, as specialists might be prisoners of their narrow paradigms

People (and among them investors):

Tend to neglect real probabilities, even when a flurry of

reliable statistics exists (see "base rate fallacy").

Or, on the other hand, tend to trust data that are flawed, reductive or
   obsolete (see numeracy bias, range estimate aversion).

Investment and risk perception

When hope and fear meddle in risk calculation.

Risk perception might be a more important factor than real risk in
market prices and returns!

Actually, investors tend to ignore the level of the real risk (supposing that
it might be known via statistic or estimated via scenario building...).

That makes them often:

Overestimate or underestimate
     either the potential rewards or the potential risk.

Adorn it, in an apparent rationality (see rationalization),

with their tastes (positive or negative feelings) by tinkering
their risk / rewards estimates. Thus,

When, they have, towards

an asset, a positive

They rationalize their

impression by seeing  
the desired asset as
highly beneficial and

When they have a

negative attitude.

They rationalize by 

considering it at the same
time risky and offering
few benefits

Those biases can be contagious, affect then many investors and
explain various outlandish
market phenomena: the average level of the equity
premium, the alternation of bubbles and crashes...

This does not mean we should
     always shun assumptions

Obviously, when facing new or rare events, for which reliable statistics
and probabilities do not exist, deciders have to start from what they
perceive, so as to make assumptions about the odds.

=> Here, the potential for subjectivity and irrational perception is high.

But there are methods (see Bayes) to try to adjust progressively
those assumptions to realities

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

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This page last update: 19/07/15  

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