10 Nov Deconstructing financial risks: subjective loss and fluctuation
What is financial risk to humans? Is it how much they can loose? Is it how predictable their returns are? Is it variance? Or something differently entirely?
When people say “something is risky” they mean it being dangerous, incurring costs, causing losses, or injuries. You can see this by how the word risk is used in the media and newspapers (Boholm, Möller, & Hansson, 2015). Financial risks, in peoples’ perception, means potentially ruining yourself. But in scientific terms, financial risk means variance (mean-squared deviation of returns). The value of a stock changes from day to day (high risk), parking money at the bank yields a fixed interest rate (low risk). I, too, define risk as variance, when researching it. The two-faced nature of risk: risk as loss and risk as variance.
Seeing risk as “loss” can explain an apparent psychological paradox in risk perception (Shefrin & Statman, 1995), namely a wrong perception of financial risks and returns. People think higher risks of investments imply lower returns. In reality, however, higher risks imply higher returns, at least tendetially, as shown by economic analyses (Dimson, Marsh, & Staunton, 2003). If people understand risk as variance, this would indeed be paradoxical. Why do they go so wrong in their perceptions? If, however, people understand risk as “loss”, the risk return paradox arises naturally. In this case, high return implies low risk (=low loss).
We test whether the notion of risk as losses can explain the paradoxical risk-return perception. In addition to this, we also propose a better way to communicate “risk” if “risk” should mean variance. The results of the first experiment (N=96) show a clear picture; and a second experiment (N=246) confirmed this picture. These will hopefully soon be published. I don’t spoil the results because I have no idea if this keeps me from publishing the paper (and my co-author was not in favor of a pre-print. I do respect his views). Let me update this post, once the manuscript is accepted.