I recently overheard a conversation that got me thinking. Friend A asked Friend B ‘where do you think I should invest now? Friend B answered with an interesting question ‘what is your biggest financial fear?’
Friend A – Not having enough money to put my daughter through school
Friend B – That’s a genuine fear and we could easily find ways to tackle it but the problem is that it could transform into some other kind of fear.
Let's say I point you towards investing in a food delivery business in Nairobi, and then a new government policy comes in and forces you out of business. Your fear then transforms into the fear of loss. Fears may morph into other kinds of fear, but when it comes to investing, risk is a constant.
It is therefore important for you to see how your fears align with the various types of risk when it comes to investing.
The conversation went on for a while but that little snippet got me thinking about fear and financial risk tolerance.
Understanding what is within our control plays a crucial role when it comes to the financial decision-making process.
According to the International Organization for Standardization (ISO), financial risk tolerance is defined as the minimum amount of uncertainty that an individual is willing to stomach when making a financial decision that entails the possibility of a loss.
It is critical when it comes to financial planning and investment decisions. As such, understanding what fuels an individual’s appetite for risk from a psychological perspective is arguably crucial in order to make better financial decisions.
A study titled Fear, Excitement and Financial Risk-Taking published by Chan Jean Lee and Eduardo B. Andrade best reveals the relation between fear, excitement and risk-taking.
In a controlled experiment, the researchers induced fear in the participants and then tasked them with undertaking two unrelated financial tasks.
One involved investing in the stock market, while the other involved taking part in an exciting high-stakes casino game.
Interestingly, the results showed that fear made the participants risk averse when it came to investing in the stock market. However, the same fear encouraged risk-taking when the financial task was an exciting casino game.
The researchers concluded that the fear of taking financial risks was heavily stifled when excitement is added into the equation.
This could explain why an individual is more likely to place a sports bet as opposed to let's say, investing in money market funds or other financial instruments.
The excitement of potentially winning the jackpot from a Ksh100 investment overrides logic, which more often than not leads to ‘chasing losses’ in the hope that one day luck will smile on the ‘investor’.
Some say ‘it’s the hope that kills’, however, some empirical studies have shown a positive effect between hope (plus other emotions) and a high-risk appetite.
The Effects of Emotions on Risk Aversion Behaviour – a journal published by Selim Aren and Berrak Koten in 2019, detailed the impact of basic emotions such as fear, sadness, anger and hope on the risk appetite of investors.
This study challenges the Utility Theory presented by Swiss Mathematician Daniel Bernoulli in 1713. The famous scientist argued that when it came to financial risk-taking, humans are all rational beings and they would thus make investment decisions after objectively evaluating their financial situation.
He opined that individuals with more wealth would be willing to take more financial risks if the rewards are high, while those with limited resources are automatically more risk-averse.
Read Also: 7 Common Investing Mistakes To Avoid
However, the growth in the field of behavioural finance over the last century has questioned the aforementioned theory by throwing emotions as well as financial literacy into the equation.
New studies have shown that if properly managed, emotions can help in making better financial decisions, while false emotional awareness such as non-fact-based excitement may lead to negative outcomes.
For example, some studies have shown that anger increases risk appetite. This is because anger often triggers a loss of control and could lead an individual to take a risky investment without considering the risk/reward possibilities.
Using the sports betting example mentioned earlier, a gambler who is angry after losing a bet is more likely to stake even higher with no regard to logic.
Fear has been seen to have a significant impact on risk tolerance as well. Stemming from past experiences, for example, an individual who has lost money after investing in a Chama in the past is likely to overlook any investment opportunities along a similar line, without making any logic-based research to examine the viability of the opportunity.
People who are afraid can’t examine the situation they are in with an objective viewpoint, and are therefore more likely to be conservative with their financial risk-taking decisions.
Now that we have a baseline in terms of the relationship between our emotions and risk tolerance, it is important to understand the common types of risk that investors face.
This way one can easily assess where they fall on the spectrum, thereby equipping them with the essential knowledge needed to make sound financial investment decisions.
Also known as inflation risk, this is the possibility that one will not be able to buy as much with their savings in the future, mainly as a result of inflation.
An individual facing this type of risk harbours fears that their decision to invest in long-term bonds means their money will ultimately lose value thereby exposing them to losses.
According to financial experts, this type of risk can be managed by investing in assets whose value tends to go up with a rise in inflation such as Real Estate Investment Trusts. One could also choose to invest in short terms bonds to mitigate this risk.
This refers to when there’s a risk that an investment will not hit the level of return that the individual had projected when they decided to invest.
People facing this kind of risk usually come face to face with the fear of not hitting personal financial targets.
For such individuals, it is important to note that the past performance of any given investment avenue does not guarantee future returns. To manage such a scenario, experts advise individuals to save more.
For instance, it is highly recommended that one should maintain at least 6 months' worth of living expenses in order to be able to handle any unforeseen loss in expected income.
This is the risk that one’s investment could take a negative hit due to political changes or instability in the country.
Individuals alert to this type of risk live in fear of losing their entire investment due to a factor that is beyond their control.
This could be in form of new tax regulations, nationwide ban of certain products such as plastic bags etc. Although it is impossible to completely eliminate this kind of risk, investors are advised to research and understand the areas of biggest risk and work to manage that exposure.
One could also diversify their investment portfolio to ensure that if one industry is hit, there is an effective contingency plan.
Read Also: 7 Ideas to Diversify Your Sources of Income
Going back to the question of where to ‘invest now’, the ideal answer would be that one should objectively re-evaluate their current situation in terms of fears as well as financial situation, and adjust based on their concerns at that particular point.
Investment decisions will always have an element of risk, therefore seeking out the most effective ways to manage these risks is paramount. Seeking expert financial advise is highly recommended as it helps to eliminate the negative impact of emotions in the decision-making process.