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Are you afraid to fail or are you a risk-taker willing to assume risk of loss in order to realize a greater gain? Is one tendency more common than the other and why?
Increasing studies and research in the area of behavioural finance are providing more insight to these types of questions. This research seeks to identify the factors that influence and guide the approaches that people take to financial risk and reward.
Back in the late 1960s and early 1970s, two Israeli scientists, Daniel Kahneman and Amos Tversky, pioneered research in the area of behavioural finance. One of their early studies was in this area of risk. Interestingly, they discovered that people are, in general, willing to take a risk to avoid a loss but far less willing to take a risk to realize a gain.
Further, our perception of gains and losses is prone to the same bias. They found that people generally experience more pain (negative feeling) with a loss than they do joy (positive feeling) with an equal gain. Apparently, the joy of gaining $100 is less than the pain of losing $100.
Could this response be more than emotional, but neurological as well? Another recent study1 published in Science Magazine demonstrated this. Volunteers engaged in a computer simulated betting game while wearing an electrode cap which recorded changes in brain electrical activity in response to winning and losing. Upon each bet made, the medial frontal cortex showed an increase in activity. However, the intriguing part was that the medial frontal negativity showed a larger dip after a loss than the rise in medial frontal positivity after a win. During a string of losses, negativity dipped lower with each event – each loss was compounded by the previous loss. The study showed that, neurologically speaking, the aversion to loss of a certain magnitude is greater than the attraction to gain of the same magnitude.
Loss aversion (also called Prospect Theory) is one of the biases that impacts our behaviour not only as investors, but as people. Perhaps you have experienced these emotions more acutely over the past eight months with the high level of volatility we have seen in the markets. Behavioural finance seeks to understand the impact of loss aversion and other personal biases on investors. The strategies you and your advisor may undertake to overcome the negative behaviours often associated with these biases might be to:
“Investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble.” – Warren Buffet
In addition to Loss Aversion/Prospect Theory, here are some other common biases that the study of behavioural finance has found:
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