12.5 Risk Aversion

AVERSION OF RISK

The reason investors tend to favour a sure thing over an alternate choice that has an equal or higher expected return can be described as being ‘risk averse’. The aversion investors have towards risk stems from two very different feelings: pride and remorse. Pride is the pleasurable feeling investors have when investments do well. Remorse is the painful feeling investors have when their investments do poorly and they second guess themselves. Remorse tends to be felt more deeply than pride. Remorse compels people to avoid situations in which the chances of their feeling remorseful are perceived to be high. Investors may also perceive risk in situations they have not experienced before. This aversion is a major cause of poor investment returns on behalf of many investors. In a study by Morning Star Mutual Funds, results from individual investors were compared against the results of the 219 growth funds they followed for the fi ve-year period ending May 31, 1994. The study showed that when an average growth stock fund gained 12.5 per cent per year over the five-year period, the average investor in those funds lost 2.2 per cent per year. What is the reason? First, investors are attracted to stocks only after the market has risen for a while and they feel comfortable. And once it is taking a correction, they display an aversion to risk. For example, a stock was consistent at around Rs100. Then it started rising. Mahesh saw it rise to Rs 105, then to Rs 110 and then to Rs 120. But he was little skeptical. When it touched Rs 120, he assured himself that it’s a good bet and bought the stock. It rose to Rs 122 and after a slight correction, dropped to Rs 118. Mahesh sold off the scrips. Thus, he lost Rs 2 per share. People often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky stock position, hoping the price will bounce back. You must have observed gamblers. During the losing streak, they will behave in similar fashion - doubling up bets in a bid to recoup what’s already been lost.

Frame Of Reference:

Another factor that affects investor decision making is the investor’s particular frame of reference at the time of a decision. Research has indicated that when choosing between two alternatives, investors’ choice is based on the current situation. The two most common investor frames of reference are situations in which: (1) You are currently making money or, (2) you are currently losing money. Normally if you are currently in a gainful position, you tend to be more risk-averse. However, if face a current prospect of loss, you tend to become more risk-seeking. This same case is also applicable in case of gambling. A study of Terrance Odean concluded that investors don’t want to take additional risks with stocks in which they have already made money. However, they will tend to hold on and risk additional losses with stocks they are currently losing money on.

Conclusion:

All investors want to make the right decisions about their investments. But research has shown that investors have a tendency for types of behavior that are not beneficial to the management of their investments. The best course of action for a portfolio may be contrary to an investor’s desire to run with the herd, shield themselves from risk and/or regret. By understanding these behavioral tendencies, as a future investor you can make a conscious effort to correct these behaviors. In the end, the best defense against these tendencies is to do a lot of homework before choosing an investment. Investors should determine their investment goals and the time frame that their money can work for them. Then, based on those determinants, pick an investment strategy and stick to it.