When risk appears low, investors can be fooled easily
Posted by: Uma Shashikant on Jul 17, 2018, 06.37 PM IST
by Uma Shashikant
As the world watched the rescue of 12 young footballers and their coach from a cave in Thailand, the reactions to the episode varied widely. While there was uniform appreciation of the heroic deeds of the rescue team and the grit of the survivors, the incident also invoked fear. The caution quotient in the mind of young trekkers and adventurers went up; parents made a lesson of the episode and filled in as much restraint as possible into the minds of their children as the teaching moments could offer; and many made lists of life skills that they should master. Such is the nature of risk perception.
It is not easy to measure risk perception and preferenceusing simple questionnaires, as we tend to routinely do in investment planning. Those ubiquitous asset allocation tools on websites are rather simplistic, quite basic in their assessment. They are needed so that the investor can check a few things in their mind before making a decision, but we may not be able to extend that tool’s usefulness and assume that it would capture risk perception accurately. That is because risk perception is complex, personal and affected by various factors.
Assume you are driving on an expressway, where the speed limit is 80kmph. You have a new fancy car, and you love the opportunity offered by a long paved road, and press the accelerator with joy. You are soon hitting 100kmph. Do you feel risk? Very unlikely. There is fun involved in what you are doing; you are exhilarated by the speed; you are admired and egged on by your co-passengers; you think the rest of the world drives carelessly, but you are a great driver. What might prompt you to slow down. Not to rubberneck and gape at the incident, but from a sudden altered risk perception about speeding on the highway.
Those are elements of risk perception that are well documented. If there is fun involved you won’t see the risk. That is why trading and taking audacious positions in stocks is seen by outsiders as risky, but the player is unable to give up the fun possibility of making some money, while punting on the stock. If you are in control, you are likely to perceive less risk. Many are convinced that driving in a car is safer than flying a plane, though statistics do not bear out that assessment. The lack of control in a plane and the high profile media attention to plane crashes enhances the risk perception of flying in the minds of many.
What might be driving the risk perceptions of investors when they make their choices? Trust is at the top of the list of factors that impact risk perception. If a road has signals, and if they all work and if the drivers obey those signals, those who drive are confident and less stressed about risks. The power of the rule of the law is that it defines behaviours and outcomes very clearly, so that people are able to make their choices and understand the consequences in a linear and simple manner.
If every event is subject to interpretation, and if a consequence cannot be imagined in advance, many will perceive a high risk. Investors remain wary of equity investing and choose insurance products with lower returns, because they find the definition of outcomes in terms of clear rupee payouts in the future as trustworthy. They trust the neighborhood finance company that just employed the local retired ex-serviceman, who innocently displays a table of deposits and payouts. That structure evokes trust and reduces risk perception, until a default event strikes and modifies it for a while.
Investors turn to risky opportunities offered by unscrupulous players—who peddle dubious investments because they know which buttons to push—in order to reduce risk perception. Someone who is selling plots of land plays on this power of imagination. The sample homes in property sales invoke aspirations and dreams to live well, and push risks of delayed readiness of the flat to the background. The possibility of owning a new ornament and one with a higher value than the amount contributed attracts buyers to subscribe to such schemes.
When investors’ attention is focused on the gain rather than the pain, the risk perception drops to the point of vulnerability. They can then be fooled into buying that highly priced IPO, that mutual fund which is being offered for Rs 10, that insurance which needs no payment after an initial period, and that bank loan which will waive a few EMIs.
The responsibility of regulators is very high in shaping the risk perception of investors. They represent the authority figure in the marketplace and have the ability to shape and modify risk perceptions. Gatekeeping is known to have a high impact on the trust perception about a particular class of players. The more trusted stock exchanges are those that have stringent listing regulations. Companies that list on them have ongoing responsibilities for information disclosure and penalties for non-compliance. It is not easy in most regimes to set up a bank to mobilise money from the public and the trust that banks evoke come from the regulator’s ability to monitor them closely.
When bank asset quality is falling and the government has to make a decision, the responsibility about risk perception weighs on the choices immensely. to shut down due to NPAs. And if the problem is widespread as it now is, this can create systemic risks – or risks across the entire spectrum – that modify risk perceptions deeply. People could take panic actions not grounded in reality and damage their assets and hurt the banking system too. But is that the justification for allowing the problem to fester, or transfer the risks to the balance sheet of an insurance business?
Thinking about consequences and actions, years after nationalizing banks and building a level of trust equated with that of the government, is the burden. Sweeping the problem under the carpet will only cause further damage. Redefining what a healthy bank is, and asking banks to realign or perish is a clean up the government has to do. And while doing so, managing the risk perception by carefully constructing the vision of healthy banks is important. That age old trust about every bankis wearing too thin to last.