Behavioural economics for smart investment and risk-aware portfolio management
Investment decisions and risk analysis
Let’s start with some unfortunate facts. Our consolidation of 27 individual studies shows that over 90% of individual investors lose money to institutions because these individuals manage their risk poorly. As experts in financial risk management, we know that apart from knowledge of risk management strategies and the ability to analyse information, a sound risk management framework involves a clear understanding of why one makes investment decisions and how one reacts to risk.
Nobel prize-winning ideas of behavioural finance backed by thousands of academic and practical studies show that individual investors are prone to myriads of suboptimal decision-making patterns. Behavioural science calls them behavioural biases, and they seriously impair long-term investment returns. Based on these ideas and studies, we have designed a unique PRAAMS BehaviouRisk Diagnostic System to determine your true investment profile and identify your unique combination of cognitive and emotional biases and their degrees. Similar to the aforementioned study, the BehaviouRisk study confirmed the result: over 99.5% (!) of investors make at least one of the 19 typical investing mistakes.
Behavioural finance studies biases and how they influence investment decisions. It asserts that investors are not perfectly rational, and that their investing- and risk-taking decisions are heavily influenced (read – determined) by psychological biases. Behavioural finance emerged as a concept many decades ago and has received many theoretical and practical affirmations. It can help anyone to make better decisions concerning their finances, and consequently has become a widely discussed topic among finance practitioners and the general investment public; even financial regulators have started to pay close attention and promote it. It would be very unwise for you to ignore the eye-opening concepts of behavioural finance and continue to invest blindfolded. Every day spent ignoring these powerful ideas exposes you to additional risks. The most significant risk is not knowing your risks!
True risk appetite – not just about risk-averse and risk-loving investment risk tolerances
Many of you heard concepts of risk-averse or risk-loving investor profiles. If not, one can use the classic risk-return relationship to describe them. When choosing among two optimal portfolios with an identical expected return, a risk-averse investor would prefer a less risky portfolio, while a risk-loving person would prefer the one with higher risk. A risk-neutral investor is driven solely by the expected return if the anticipated risks are equal.
However, ascertaining the true risk profile of an investor is much more complex and has more nuances. Behavioural economists and psychologists have discovered over 200 biases and, on many occasions, assigned different names to almost identical concepts. We have two pieces of good news. First, only some of these biases are relevant when it comes to asset allocation. At PRAAMS, we focus on the 19 most common and significant behavioural biases that have the greatest effects on individual portfolio management. We discuss the most popular biases like confirmation, hindsight and recency, and the most harmful and widespread biases, including overconfidence, affinity, availability, and loss aversion. Second, we use well-established terminology and merge closely related concepts to maximise clarity and save you time.
Sound portfolio management is more than just standard risk tolerance questionnaires
Asset allocation theory says that each investor has his own risk profile or risk tolerance, i.e., a maximum amount of risk he is comfortable assuming. Investors with substantial risk tolerance are comfortable with high-risk instruments, while those with minimal risk tolerance shall limit the risk in their portfolios. Any risk mismatch impairs long-term returns: taking greater risks than one can manage leads to losses while avoiding risks when one can handle them diminishes potential return because risk and return are connected. The first mistake is far more detrimental.
It is essential to understand your true risk tolerance correctly to comfortably achieve your financial goals and manage portfolio risks. Standard risk-profiling questionnaires, such as the one you are likely to have been given by your investment firm, are oversimplistic and incomplete. Conflict of interest and mis-selling aside, the approach focuses only on external factors such as investment objectives, experience and investment horizon. It ignores the critical influence of your unique biases. Your real risk profile is a combination of external and internal factors, and BehaviouRisk helps you to ascertain this. When you know your true risk tolerance, you will no longer be misled by financial advisors who try to sell you unsuitable products passed off as so-called ‘trade ideas’.
PRAAMS BehaviouRisk – risk management tool to enhance risk profiling
Standard risk profiling, if done correctly, is a vital first step in designing an efficient portfolio. Yet, it is only halfway. To be truly effective, behavioural investment profiling must enhance and validate it. Standard risk profiling focuses on quantitative aspects (investing experience, time horizon, personal assets and liabilities etc.). In contrast, behavioural investment profiling focuses on qualitative or psychological aspects described in terms of the presence of cognitive and emotional biases and their degree. Behavioural investment profiling confirms that a person is highly risk-tolerant when he has no cognitive or emotional biases, or these are of a limited nature, i.e., this person is capable of consistently making rational decisions and is free of unwarranted emotions (like Mr Spock).
At PRAAMS, we have designed a unique behavioural investment profiling tool BehaviouRisk Diagnostic System. BehaviouRisk is based on behavioural finance ideas and helps individuals to become better and more intelligent, risk-aware investors. We are delighted to offer you this opportunity to obtain a personalised report and give yourself a distinct investing advantage.
It is important to remember that behavioural investment profiling is just one of the key elements to successful investing. Others include Asset risk profiling and Analytica, which help you analyse risks and returns of every investment globally, Portfolio Auditor and Portfolio Selector to check key portfolio metrics and explore new investment opportunities, and the Volatility predictor to monitor instrument performance and de-risk before the storms. Leave your email at praa.ms to be the first to receive these services soon.
Our book on practical behavioural finance for risk-aware investors
At PRAAMS, we are committed to providing independent, confidential, and professional risk management and asset management service to individual investors worldwide to help them risk less and earn more. Today, you can try BehaviouRisk to ascertain your true risk profile and correct your investing mistakes. Also, you can read our book “Practical Behavioural Finance for Risk-Aware Investors”. It has already helped many individual investors worldwide, and 92% of readers rated this book ‘very useful’.
Join the PRAAMS risk-aware community on Medium, Facebook, LinkedIn, Instagram, YouTube, and other social media platforms and consider sharing your new knowledge and this book with others to help them achieve their goals and make financial markets a better place for everyone.
We wish you the best of luck in what we believe will be a fascinating journey to becoming an intelligent, risk-aware investor. It may not be easy, but this is a valuable investment in yourself.