What drives our investment decisions? Inertia

How did people respond when they saw their wealth melt away in the stock market? To read most press accounts, investors’ “risk tolerance” changed in recent months as a result. They aren’t willing to take the same risks in the past, now that they don’t have the money. The story line is simple: twice bitten, once shy.

Economics though, has surprisingly complex – and contradictory – theories about how investors’ attitude towards risk should change when their wealth goes down. According to most behavioral theories, if you are in a hole, you are willing to take even more risk with what money you have left, to try to get back to even. Think of a gambler doubling down when things go wrong. But maybe people are so traumatized by losing money, they refuse to take any more risks, and hunker down with what they have left. Or maybe it doesn’t make any difference: many common theories in economics claim investors risk aversion doesn’t change one way or another in relation to changes in wealth.
So which one is it? Looking at how people actually behaved in terms of their investment choices, once they have lost or made money, it is possible to reverse engineer an answer to this murky psychological question. Which is exactly the approach taken by two economists, Stefan Nagel and Marcus Brunnermeier. They looked at the portfolios of people whose wealth had changed, to see if it changed the way they invested afterwards. Here is what they found: none of the psychological models developed by economists really worked.

People who suddenly got richer, didn’t now start investing in riskier assets. But people whose wealth went down didn’t make dramatic changes in their portfolio either. In fact the most compelling finding is investors didn’t do much of anything differently. They pretty much left their asset allocation in their investment portfolio untouched, regardless of changes in wealth.  (You can read the original research here).

Which shows yet again, that we aren’t motivated only by fear or greed when it comes finance. Instead, when we have to actually make a financial choice…inertia rules.

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