It’s well recognized that your asset allocation should be largely determined by your willingness, ability, and need to take risks.
While your need and ability to take risks are primarily financial, your willingness to do so is largely psychological.
Though you may need to take some risks to meet your financial goals, and you may have the ability to do so (e.g., you’re young and have a secure, well paying job), these things have to be balanced against your risk tolerance. If not, you’re just asking for trouble.
Characterizing risk tolerance
A common approach to this problem is to work your way through a risk tolerance questionnaire that asks about your timeframe, your comfort level with investments whose values fluctuate over time, how you would react if the stock market suddenly lost X% in Y months (where X is large and Y is small), and so forth.
And at the end, you’re pigeon-holed into a certain risk tolerance category. Setting aside for the moment whether or not such surveys are effective or useful…
What determines risk tolerance?
Have you ever wondered what actually determines your risk tolerance? That is, why might two different people in very similar financial circumstances having very different attitudes toward risk? One may be perfectly willing to take on huge financial risks while the other is extremely risk averse.
The underlying causes are undoubtedly complex and there are like to be no easy answers. That being said, I recently ran across an interesting study that looked at the effects of social isolation on financial risk-taking.
The effects of social isolation
The research I’m talking about was based on a series of experiments as well a relatively large field survey. And the results suggested that social isolation tends to encourage riskier financial behavior.
In one case, for example, participants played an online ball-tossing game where their level of inclusion was manipulated. They were later asked to choose between a high risk/high reward and a low risk/low reward gambling opportunity.
Care to guess what happened? As it turns out, those who had been relatively more isolated in the game were more likely to choose the riskier alternative than those who had a more inclusive experience.
In a separate experiment, the study’s author sought to determine the direction of the effects. Were those who were isolated shifting toward riskier behaviors, or were those who were included shifting toward lower risk behaviors? Overall, they found that social rejection is the driving force behind their findings.
Why? In this case, they chalked it up to the “instrumentality of money.” That is, study participants seemed to view money as a means to obtain what they want in life and thus, when faced with rejection, they pursued riskier but more (potentially) rewarding financial endeavors.
Finally, they used survey data to investigate the extent to which their findings could be generalized beyond their experimental setting. Interestingly, they found that chronic feelings of social exclusion are strongly correlated with a tendency to engage in risky personal financial behaviors.
So there you have it… It appears that your social situation has the potential to have a major impact on your willingness to take financial risks. Investor, know thyself.