Perception of risk in investment decisions is an emerging topic in behavioral finance discussions. Inspired by recent Chinese financial market turbulence, I will briefly present here main points of the risk perception issue, mainly picked up from much more descriptive Victor Ricciardi's article (Ricciardi, 2010) [1], which I found suitable for a blog form.


1. Perception of Risk

Perception is how we become conscious about the world and ourselves in the world. Perception is also fundamental to understanding behavior since this process is the technique by which stimuli affect an individual. In other words, perception is a method by which a person organizes and interprets their sensory intuitions in order to give meaning to their environment regarding their awareness of “events” or “things” rather than simply characteristics or qualities. The process of perception involves a search for the best explanation of sensory information an individual can arrive at based on a person’s knowledge and past experience. (Ricciardi, 2010) [1]

Risk perception is the way people “see” or “feel” toward a potential danger or hazard. The concept of risk perception attempts to explain the evaluation of a risky situation (event) on the basis of instinctive and complex decision making, personal knowledge, and acquired information from the outside environment. (Ricciardi, 2010) [1]

Falconer (2002) [2] provided this viewpoint: "Although we use the term risk perception to mean how people react to various risks, in fact it is probably truer to state that people react to hazards rather that the more nebulous concept of risk. These reactions have a number of dimensions and are not simply reactions to physical hazard itself, but they are shaped by the value systems held by individuals and groups." (p. 1)


2. Standard Finance Viewpoint vs Behavioral Finance Viewpoint

The standard finance academic’s viewpoint is that investors make decisions according to the assumptions of the efficient market hypothesis. Modern financial theory (standard finance) is based on the premise that individuals are rational in their approach to their investment decisions. Supporters of the efficient market philosophy believe that current prices already reflect all knowledge (information) needed about a financial rmarket.

The behavioral finance literature’s perspective is that individuals make judgments based on and are influenced by heuristics, cognitive factors, and affective (emotional) issues. Behavioral finance focuses on the theories and concepts that influence the risk judgment and final decision-making process of investors, which includes factors known as cognitive bias or mental mistakes (errors). (Ricciardi, 2004, 2006) [3] and [4] Researchers in financial psychology (behavioral finance) have conducted studies that have shown humans are remarkably illogical regarding their money, finances, and investments. (many sources, e.g. Ricciardi, (2006) [4]).


3. Concepts from Behavioral Finance about Risk Perception in Investment Decisions

The prevalent cognitive issues and affective (emotional) factors of behavioral finance that influence a person’s perception of risk are including: heuristics, overconfidence, prospect theory, loss aversion, representativeness, framing, anchoring, familiarity bias, perceived control, expert knowledge, affect (feelings), and worry.

For example, heuristics are simple and general rules a person employs to solve a specific category of problems under conditions that involve a high degree of risk-taking behavior and uncertainty. In various experiments in psychology, the findings have revealed individuals tend to be biased by information that is easier to recall, influenced by information that is vivid, well-publicized, or recent. An individual that employs the availability heuristic will be guided to judge the degree of risk of a behavior or hazardous activity as highly probable or frequent if examples of it are easy to remember or visualize.

Overconfidence is another characteristic that influences a person’s risk perception since there are many ways in which an individual tends to be overconfident about their decisions in terms of risk-taking behavior. It is an overestimation of the accuracy of our current knowledge which may lead to numerous investment mistakes.

Representativeness reflects the belief that a member of a category (e.g., risky behavior or hazardous activity) should resemble others in the same class and that, in effect, should resemble the cause that produced it. Ricciardi and Simon (2001) [5] provided this perspective: "Representativeness is but one of a number of heuristics that people use to render complex problems manageable. The concept of representativeness proposes that humans have an automatic inclination to make judgments based on the similarity of items, or predict future uncertain events by taking a small portion of data and drawing a holistic conclusion." (p. 21)

More detailed description of all above mentioned factors may be found in Ricciardi's article (2010) [1]


4. Conclusions

Classical decision making is the foundation of standard finance since it is based on the notion of rationality in which investors formulate financial decisions. Anyway, standard finance has discarded the view that the decision-making process is influenced by psychology in which individuals are sometimes prevented from making the most rational decisions. Behavioral finance is based on the premise that investors make decisions influenced by bounded rationality, that is their financial decisions are influenced also by feelings, affects and emotions. For instance, an investor displays cognitive and affective (emotional) issues during the decision-making process in the assessment of risk and the evaluation of a specific investment product or service.


5. References

[1] Ricciardi, V. (2010), "The Psychology of Risk: The Behavioral Finance Perspective", SSRN-id 1155822

[2] Falconer, L. (2002), "The influences of risk perception", Working paper (abridged version). University of Bath

[3] Ricciardi, V. (2004),  "A risk perception primer: A narrative research review of the risk perception literature in behavioral accounting and behavioral finance", Working paper

[4] Ricciardi, V. (2006),  "A research starting point for the new scholar: A unique perspective of behavioral finance", ICFAI Journal of Behavioral Finance 3, 3: 6 - 23 

[5] Ricciardi, V., and Simon, H. (2001), "Behavioral finance: A new perspective for investors and financial professionals", Working paper


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