The stock market’s sharp swings earlier this month, after
three years of steady profits, weren’t nearly steep enough to remind us all how
much it hurts to lose money. Because people have a remarkable ability to
distort their own memories, investors who panicked in 2008 and 2009 may be
kidding themselves about their ability to survive another crisis. And the
typical “risk-tolerance quiz” used by financial advisers is almost useless
in predicting how you will react to losses, because perceptions of risk vary so
widely.
Increasingly, scientists are tackling the problem. A new
study, just published in the prestigious Journal of Neuroscience by a
team of researchers found that the density of cells in one region of the brain
predicts how willing people are to take financial risk. This research appears
to “provide the first link between brain structure and risky choice,” says
neuroscientist Scott Huettel of Duke University, who wasn’t involved in the
study.
Jason Zweig recently volunteered as a guinea pig in the same
experiment, which has been run on more than five dozen people; the results have
been controlled for age and sex. A scan of his brain showed that the thickness
of gray matter in the right posterior parietal cortex—a small area toward the
rear crest of my skull—is slightly below average. Sure enough, when the
researchers tested his risk tolerance, they found that it is also slightly
below average.
One of the study’s authors suggest that people who have
chunk of gray matter in the area, on average, have a greater tolerance for
financial risk.
For most investors, the most-damaging risk is probably what
Greg Davies, head of behavioral finance at Barclays Wealth and Investment
Management, a unit of Barclays PLC, calls “deviating from your long-term plan
in pursuit of short-term emotional comfort in a time of unease.”
When will pain exhaust your patience? Science can’t
determine that yet. But you might be able to if you give honest answers to
questions like these:
– “What did I do in
2008 and 2009?” Your memories of cowering under your desk or being
glued to financial television have probably faded. So the only way to tell for
sure is to dig up your old account statements. If you sold in 2008 and 2009,
you probably will sell in the next panic, too—so you better not have greater
stock exposure now than you did in 2007.
– “How flexible are
my goals?” Your ability to withstand risk depends partly on how much
money you have—but also on how much you plan on spending in the future. If you
absolutely have to buy that expensive house in the next year, your capacity for
taking risk is more limited than your cash balance might imply.
– “What risks have I
protected against?” Many financial advisers have loaded up their
clients on assets like high-yield bonds, emerging-market debt and bank-loan
funds. In a crisis, these income-producing but risky investments tend to go
down at least as much as U.S. stocks. The best insurance against a drop in
stocks is plenty of cash and investment-grade bonds; make sure you have it now.
– “Have I turned
rules into habits?” It’s human nature to believe, when times are calm,
that you will do the right thing in the heat of the moment. But you can be
placid in a panic only if you have practiced rules until they have become
habits. If you obsessively checked the value of your portfolio earlier this
month, you need to ban yourself from looking at your accounts while the market
is open. And if you can’t turn that rule into a habit, you probably have too
much in stocks for your own good.
Click here to access the full
article on The Wall Street Journal.