“The older I get, the less I depend on the mathematics of investing and the more attention I pay to the psychological and the emotional aspects of investing,” Bill Bernstein told Morningstar’s Christine Benz and Jeff Ptak on The Long View podcast recently.
As storytellers, humans are great at creating narratives about our experiences. There is a very compelling narrative in success stories, thinking, ‘The next time it will be us.’ It could explain why so many people like to read about others who have won the lottery.
On the flip side, negative experiences, like perceived failure, can modulate how our brains respond to future experiences with the same or similar stimuli. Being aware of this neurochemical footprint can inform how we want to approach future risks, both in life and in investing.
Financial Risk Tolerance Vs Risk Perception: Why it Matters
What is financial risk and why do we want to avoid it so badly? Risk can be broken into two different parts.
- Risk tolerance, and
- Risk perception
Sarah Newcomb, a behavioural economist, says, “Risk tolerance is a person’s general attitude toward risk/reward trade-offs. It refers to the amount of risk a person is willing to take on for a particular reward. A person with a very low risk tolerance will not want to risk losses, even if the gains could be substantial. A person with a higher tolerance for risk will be willing to experience losses in pursuit of sizable enough gains. A person establishes their risk tolerance using what is commonly referred to as System 2 thinking. System 2 is characterized by slow, deliberate thought that is largely devoid of emotional influence.”
“Risk perception refers to how risky a specific action feels to an individual. Risk perception is an in-the-moment estimation of the riskiness of an action or event, and thus it can be affected by emotion, culture, past performance, and even nuances of information like wording, color, and graphics.”
Where Does Stress Fit into All This?
Let’s start by defining what stress is.
According to Experimental & Molecular Medicine, “Hans Selye, who coined the term “stress” to describe ‘the non-specific response of the body to any demand for change’ in 1936, stated in his later years that “Everyone knows what stress is, but nobody really knows about stress”
What does stress have to do with dopamine? “Stress affects dopamine levels and dopaminergic neuronal activity in the mesolimbic dopamine system” the Experimental & Molecular Medicine notes.
Basically, stress and dopamine are tied together in our brains. We've evolved to react to stress with changes in our dopamine levels so we can be responsive to something happening in our environment.
But wait. After our article last week, you may be thinking, wait, I thought dopamine was about reward? Fact is, dopamine levels rise in the brain when responding to both aversive and rewarding stimuli.
Experimental & Molecular Medicine notes that,“changes in dopaminergic neurotransmission can modify and alter behavioral responses to different environmental stimuli that are associated with reward anticipation. Stressful events often include aversion and avoidance, which may negatively regulate the dopaminergic reward system.”
When you react to a stressful situation your brain wants to avoid the discomfort. When you avoid dealing with stressful situations your brain rewards you with a flood of dopamine. Stress also affects adrenaline levels which can put your body into a fight or flight response. Depending on whether we listen to our fight or flight instinct, we can avoid good decisions or make bad ones.
How Stress Impacts Investing
So, what does this all mean in relation to investing? Where does financial stress fit in?
While in fight or flight mode, our body is focused on survival, which leaves us in a state where we aren’t going to make the best decisions. Dopamine reduces inhibition and also makes us prone to poor decision making.
We want to make sure that we are making decisions in a clear, calm headspace, not under pressure. Finances can be stressful, but stress shouldn’t drive our decisions.
Risk Is Unavoidable. Panic Is Optional.
As Newcomb points out, as investors, we cannot entirely eliminate risk. You should diversify your investments, research your holdings, and select a strategy that suits your overall tolerance for risk. Even so, if you have any “skin in the game,” you will likely feel anxious from time to time.
She offers some tips for coping with fear and stress:
- Anxiety reappraisal. There are physiological similarities of anxiety and excitement, and the technique known as anxiety reappraisal can help improve decision-making in stressful situations. You can learn more about that here.
- Silence the talking heads. Since the delivery of information can affect how you feel (and thus how you view risk) there are times when we simply need to shut off the TV and walk away. The pressure to make everything into a crisis is heavy upon them, but you don’t have to carry the weight of their messages on your shoulders.
- Talk with a trusted financial professional. If you have a financial advisor, ask them to help you get a big-picture perspective. Often the crisis du jour is just a blip on an otherwise upward trend.
Fear and stress have the power to change our perceptions of risk, skewing what we think is probable toward the negative. “Because fear and uncertainty are uncomfortable, we can be drawn into actions to try to reduce uncertainty. This might take the form of research and information-seeking. Research is great, but we need to be watchful of how the information we ingest is presented because the format, language, and tone can itself magnify our fears. Since risk is unavoidable in investing, we’d be wise to learn and practice emotional coping skills to combat the potential negative effects of fear on our investment behaviour,” says Newcomb.
