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Risk and rationality, investment and life

Posted by Graeme in Business & Investment,Life at 12:09 pm on Wednesday, 24 November 2010

Its fairly obvious that people are not, except for a few analytical souls, rational about risk: they worry obsessively about small risks and ignore ones that matter, and they are often no more rational about investing.

Its easy to reel off examples of irrationality about risk in everyday life. My favourite are people who took to commuting in London by motorbike because they were worried about the risk of terrorism on public transport. Minuscule risk against significant one. I am not sure what one can do legally as a regular part of everyday life that is more dangerous — I add those qualifications because of things like extreme sports (legal, but not usually a part of everyday life) and shooting heroin (A part of some people’s everyday life, but not legal) which are more dangerous.

Surely, when people are assessing what to invest in they will try to be more rational? I very much doubt they even try, and they certainly do not succeed. Buying into bubbles, buying complex investments they do not understand, refusing perfectly good investments because returns have not been good in the short term,……… and on and on and on.

Well at least those well paid, highly trained, professional investors who we trust our money to will be more rational. Like lemmings.

These are the people who come up with bright ideas like hedging with knock out options. This is like buying motor insurance that only covers the first £1,000 of damages: it covers the most likely eventualities, but is of no use when you really need it.

It can work quite well if you are looking after other people’s money (you can set things up so that you will probably out-perform, but a crash will wipe out the portfolio — no idea how often it really happens much), and is even better for packaging up into structured products with “guaranteed returns” that you then sell to people who have no idea how to value something so complex: of course the terms are not that complex so the unwashed have no idea that the valuation certainly is.

The point of all this is that financial theory makes the assumption that people are risk averse (which is probably near enough true) and that people assess risk rationally to protect their wealth. They do not. They assess risk irrationally and they entrust their wealth to people whose incentives to avoid risk are not consistent with their risk aversion.

That seems to make it likely that prices will diverge from what a rational investor would pay: the market is not perfectly efficient. I still think you should value securities with CAPM because you should value them at what a rational investor would pay.

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