The Psychology of Investing by John R. Nofsinger

Author:John R. Nofsinger [Nofsinger, John R.]
Language: eng
Format: epub, pdf
ISBN: 9781138714809
Publisher: Taylor and Francis
Published: 2017-07-27T23:00:00+00:00

Preferred Risk Habitat People try to match their level of risk aversion to their investments. However, they do not appear to match their preferred risk level to the risk of their total portfolio. Instead, they tend to use their desired risk level to help them pick each of the individual components that make up the portfolio. That is, investors break up the complex portfolio creation decision into simpler subproblems of finding portfolio components. Each component matches the investor’s preferred risk level.

Consider this illustration. Say that an investor decides that his level of risk aversion is such that it matches an investment volatility (standard deviation) of 50 percent. His investment opportunity set includes stocks with increasing levels of risk measured as volatilities of 20, 30, 40, 50, 60, 70, and 80 percent. How does he match his investments to his risk level? One possibility is that if he narrowly frames each stock individually, he could allocate half of the portfolio to the lowest risk stock (of 20 percent volatility) and half to the highest risk stock (of 80 percent volatility) and have a portfolio with average volatility of 50 percent the desired level. A second possibility is that he could allocate to the middle volatility stocks (40, 50, and 60 percent) to form the desired average risk level. A third option would be to take the modern portfolio approach and view the stocks from a broader frame. Combining the stocks might create diversification effects that would lower the total portfolio risk. So he could pick the riskier stocks (60, 70, and 80 percent volatility) and create a total portfolio volatility of the desired 50 percent.

Which of these three options describe investor behavior? Dan Dorn and Gur Huberman argue that investors tend to behave like the second option.10 They select a level of risk and then pick individual stocks, all with that risk profile. By examining over 20,000 clients at a German broker, they find that investors tend to pick a preferred risk habitat and then pick from the stocks in that habitat. When they replace a stock in their portfolio, they buy a new stock that is in the same risk habitat as the one sold. Lastly, they find that those investors who are most prone to specializing in a risk habitat underperform other investors because they take too much diver-sifiable risk. They would be better off thinking more broadly and designing a diversified portfolio with total risk that matches the risk habitat.

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