Behavioral Finance paper on assessing risk

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bobcat2
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Behavioral Finance paper on assessing risk

Post by bobcat2 » Sun Aug 05, 2018 1:08 pm

Last Sunday after the DC Bogleheads meeting a group of us went out to dinner. Meeting presenter Arun Muralidhar and his 18 year old son, Sid, joined us. Sid is a computer whiz and set up his dad's video display equipment for the presentation.

At the dinner I spoke with Sid and his dad. Later last week Arun was driving Sid to Virginia Tech to begin his college career where he intends to major in behavioral finance. Sid, while in high school, had written two papers in behavioral finance for the Journal of Personal Finance. The first paper, What's Your Risk Appetite? Helping Financial Advisors Better Serve Clients, has already been published and the second paper is scheduled to be published later this year. Here is a link to Sid's first paper, co-authored with fellow 11th grader Emerson Berlik.

Link - https://drive.google.com/file/d/1gXnXvB ... sp=sharing

Here are some of the people listed in the acknowledgements section of the paper: Daniel Kahneman, Andrew Lo, Wade Pfau, Hersch Sheffrin, and Meir Statman. Dad is justifiably very proud.

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

livesoft
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Re: Behavioral Finance paper on assessing risk

Post by livesoft » Sun Aug 05, 2018 1:34 pm

You know about that high school, right? ;)
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nedsaid
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Re: Behavioral Finance paper on assessing risk

Post by nedsaid » Sun Aug 05, 2018 1:39 pm

Great stuff, Bob. This 18 year old kid is wise beyond his years. A couple of takeaways below.

The financial decisions they make are influenced by their financial literacy and their
behavioral biases, and sadly the data on financial literacy is not promising as Lusardi
and Mitchell (2014) demonstrate that many adults cannot answer basic questions about
compounding, inflation, or diversification.
Nedsaid: Indeed, at least half of Americans cannot even balance their checkbook. They just call the bank to find out how much is in there, oblivious to the concept of outstanding checks.

Further, robo-advisors ask very naïve questions to gauge risk appetite. For example, a robo-advisor’s only question about risk tolerance to establish a portfolio is whether the investor cares more about maximizing gains, minimizing losses or both equally.
This is true for all the questionnaires I have taken from financial companies. Nedsaid's rule of thumb is to reduce the recommended allocation to stocks by 10% to 15%. There seems to be a bias in the surveys towards more aggressive stock allocations.

The author of the paper seems to think that risk tolerance can be quantified. I am not so sure. During bull markets, I am very risk tolerant. During bear markets, my risk tolerance somehow, as if by magic, shrinks. How does that happen? :wink: I will read on and comment more.

The father of this young man is justifiably proud.
A fool and his money are good for business.

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bobcat2
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Re: Behavioral Finance paper on assessing risk

Post by bobcat2 » Sun Aug 05, 2018 1:46 pm

livesoft wrote:
Sun Aug 05, 2018 1:34 pm
You know about that high school, right? ;)
I know beginning last Sunday. :D

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

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Re: Behavioral Finance paper on assessing risk

Post by nedsaid » Sun Aug 05, 2018 2:21 pm

The paper had a surprising conclusion that people are risk averse in relation to gains but risk seeking in relation to losses. I would expect the opposite.

We often see that people will double down on risk after a loss to recover lost ground and to make gains. The reality is that the odds are the same each time you roll the dice, fate doesn't remember that you are due for a big win. In other words, the odds of a particular combination are 1:36 each time you roll the dice. Accountants have the concept of sunk cost, a cost that has been incurred and cannot be recovered. I am trying but probably failing to explain the concept of anchoring.

The opposite mistake would be to get too conservative after a loss, in effect locking in the loss. The fellow who invests in stocks, shows a loss, then locking in the loss by selling and going to cash investments and not investing in stocks again.

The paper says that people are not adverse to potential losses but to actual losses. I have said this a different way, that is that simulations with fake investments and fake money cannot reproduce the emotions that occur when real money and real investments are involved. The difference between losing in Monopoly and losing in real life. This is why I think that questionnaires and psychological tests have limited usefulness. The participants know it isn't real and the consequences for failure are zero. But it is useful and much better than nothing. Probably better to study real life behavior in real life markets and see if they match up to the questionnaires and testing.

But yes, I am at peace knowing that stocks can drop by more than 50%, I accept that risk in theory. But when that loss actually shows up, the result is quite emotionally painful.

Here is an interesting excerpt here:
Making individuals or even groups of individuals aware of their risk appetite has interesting implications for not only portfolio selection, but also for other decisions with social impact.
For example, some have argued that girls tend to be more risk averse than boys and this can
affect career choices and even test scores such as the SAT (Baldiga 2014). By making girls
aware of their risk biases, research has shown that they could be educated into not always choosing the safe option which could improve test scores and their future career prospects (Kachnowski 2017). Further, many colleges admit students for entrepreneurship courses and do not
have a clear way of distinguishing which students have the appropriate risk appetite to succeed as risk-takers (as SAT scores do not provide such clarity). Hence, this formalization of the value function can have positive externalities outside finance.
In a similar fashion, if investors are aware of their risk appetite and their biases, this would help them towards better behavior.

Another interesting comment in the white paper is that loss aversion decreases with education. I wonder if this is overconfidence. One can know a lot but still less than he or she thinks they know.

Lots of good stuff here.
A fool and his money are good for business.

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Re: Behavioral Finance paper on assessing risk

Post by Fallible » Sun Aug 05, 2018 6:00 pm

Thanks for posting and I can see why Sid's dad is very proud.

One question I have (probably because I missed something somewhere): did the two students create Riskstyle and are introducing it in this paper for the first time? Also, I tried to open Risktyle.com, but nothing came up.
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Theoretical
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Re: Behavioral Finance paper on assessing risk

Post by Theoretical » Mon Aug 06, 2018 8:52 am

The paper had a surprising conclusion that people are risk averse in relation to gains but risk seeking in relation to losses. I would expect the opposite.
This is consistent with the kind of behavior trend followers observe and try to exploit. It’s the risk of being too early in contrarianism - “fearful when others are greedy or vice versa.”

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