The Impact of Emotions on Risk Tolerance
A new study examined the impact of emotions on investments, financial risk and life in general, providing important insights and lessons for advisors.
Behavioral finance is the study of human behavior and how that behavior leads to investment errors – investors do not optimally trade off risk and expected returns to maximize the utility of their end-of-period wealth. This can even lead to mispricing of assets (anomalies for asset pricing models). The field has gained an increasing amount of attention in academia over the past 20 years or so, with the Nobel Memorial Prize in Economic Sciences awarded to psychologist and economist Daniel Kahneman, and behavioral science and finance professor Richard Thaler.
Chris Brooks, Ivan Sangiorgi, Anastasiya Saraeva, Carola Hillenbrand and Kevin Money contribute to the behavioral finance literature with their April 2020 study “The Importance of Staying Positive: The Impact of Emotions on Attitude to Risk.” They examined the impact of emotions towards financial investments and emotions towards life in general on attitudes to financial risk using data from a June 2017 questionnaire of 970 U.K.-based retail investors. Among the control variables were age, gender, investment experience, investment knowledge (both self-assessed and using a simple five-question test that is a subset of a FINRA 15-question test) and educational level.
Following is a summary of their most interesting findings:
- In terms of financial knowledge, only 12% of respondents were unable to answer any of the five most basic questions correctly; 22% got one correct; 23% got two correct; 26% got three correct; 13% got four correct; and only 4% answered all five questions correctly.
- Investors have stronger positive than negative emotions towards investing.
- Risk tolerance monotonically increases with positive emotions towards investments and life, and decreases with negative emotions.
- Perhaps surprisingly, positive emotions have a stronger impact on risk tolerance than negative emotions.