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The Risk Trap

Following the credit crisis in 2008 a well-known investor was asked what we would learn from the ...
Newstalk
Newstalk

11.34 16 Apr 2014


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The Risk Trap

The Risk Trap

Newstalk
Newstalk

11.34 16 Apr 2014


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Following the credit crisis in 2008 a well-known investor was asked what we would learn from the crash. His response was, “A lot in the short term, a little in the medium and absolutely nothing in the long term.”

Human perception of risk is leading us to repeat the same mistakes again and again.

So are we are condemned to an endless cycle of booms followed by busts or is there a better way to understand market risks and risk in general with the advent of new work in the field of behavioural finance?

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While market movements can be highly random and thus difficult to predict, human reaction to risk and reward by contrast is much easier to model. The clue to this phenomenon is found in pattern recognition and our incredible innate ability to recognise and reorganise data into something that makes sense.

Read the line below, the fact that you can read it is because you have this ability too.

How cmoe yuor bairn is albe to udnertsnad tihs snetnece eevn tghouh olny the frist and lsat ltetres of ecah wrod are crreoct?

In fact we all do. Our ability to recognise patterns goes back to the moment we are born and look into our mother’s eyes. Over our lives the average human will be able to recognise up to seven thousand faces and remember countless numbers, names, streets and other facts all as a result of pattern recognition.

Recognising patterns does not just help with organising data, though it has been a critical element in our survival as a species. When man was not as dominant on Earth as we are today it was essential to be able to recognise predators as early as possible. Time really mattered as failure to recognise the danger meant you could become the predator’s next meal. Thus recognising imprecise shapes in the shadows is a survival mechanism. If it looks like a tiger, then it probably is a tiger - so run! You can work out if it was a tiger or not later.

That kind of pattern recognition is all well and good for escaping tigers and is engrained in our DNA, however, it is an awful way to deal with most risks in the modern world and particularly with financial market risk.

The field of behavioural finance, a cross between behavioural psychology and finance has some of the answers. It explains a number of different heuristics or learnt behaviours such as “herding” - how we behave in groups - and “anchoring” - the salesman’s trick of naming the first price in a transaction in order to anchor the buyer to a higher point from which to commence negotiations.

Another heuristic is “recency bias” whereby we favour the most recent information in making a decision rather than considering more relevant other information. Written like this heuristics seem obvious but the interesting thing about behaviour is that in these examples they are all learnt and we have a devil of a job of undoing that learning.

Another aspect of behavioural finance that is both intriguing and highly predictable is human perception of risk. In figure 1 below you can see a typical asset bubble. This could be house prices, stock markets prices or for that matter any asset price bubble.

Human Perception of Risk Image: CheckRisk LLP

The diagram shows a conceptual framework of how humans perceive risk. The green line is a typical asset bubble. In order for a bubble to get started you need some kind of displacement, like the invention of the motorcar, internet or personal computing for example and easy credit.

With those ingredients a bubble starts off and is soon picked up by outsiders who push the price of the bubble higher. Eventually it becomes clear that the price is not sustainable and the first investors exit, swiftly followed by professionals in the know, leaving individuals to pick up the pieces. During this whole cycle the red line represents real risk. In this case, real risk is the price an investor is willing to pay over and above the real value of the asset. So in the bottom left-hand corner an investor is “getting paid to take risk” because the red line is below the green. As they cross the investment is risk neutral and anywhere above there is a risk premium being paid.

The blue line is our human perception of risk. Go to the top left-hand corner. Here, human perception of risk is very high, that is to say highly risk-averse. The reason being that we will have just come off the previous bust cycle - investors will have lost money and not wish to invest.

However, as the green and red lines rise, investors start to make money. At that point heuristics like herding, recency bias and reward bias kick in. Our level of risk appreciation falls until we arrive in a semi-perpetual state of risk remission. We just don’t want to see the risks even though they exist and are obvious. Effectively we want to stay at the party. At around the same time real risks are getting close to peaking. Our appreciation of risk may be at its lowest just as risk climaxes. The risk trap is set.

This perception of risk to real risk concept has now been modelled. If we are to learn anything other than just in the short term and thus avoid mistakes in the future then understanding how we behave with risk may just be the key.


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