One of the topics that constantly fascinates me is how to elicit investor’s goals and their attitudes towards risk. I have helped write and publish a free collection of essays for practitioners that I still think is valuable to anyone working in wealth management or retail banking.
One of the perennial questions about risk aversion – or to be more precise, loss aversion – is what characteristics drive attitudes towards risk? It is well-known that higher stakes make people more loss averse. A recent study by researchers of the Pensions Institute of Cass Business School in London tested an entire battery of characteristics on a representative sample of more than 4,000 Brits. Faced with the prospect of winning or losing £10, the average loss aversion was 1.21, meaning that participants required an expected gain of £10 x 1.21 = £12.10 to participate in a lottery with a 50% chance of losing £10. When the stakes were raised to a potential loss of £1,000, the loss aversion doubled to 2.41. This level-dependency of loss aversion is why I always emphasise that investors should be confronted with losses that are representative of their investments and their wealth. For a millionaire, losing £1,000 in his investments happens practically every day. For a person living off the minimum wage, losing £1,000 can be devastating.
Loss aversion also depends on age, though not in the way you might expect. Traditionally we assume that older people should be more loss averse because they depend more on the income generated by their investments and have a shorter investment horizon. And we do observe that as people approach the age of 50, loss aversion starts to increase. But young people in their 20s and early 30s are just as loss averse as retirees. These young people should ideally invest in lots of equities and other risky assets because they can ride out any short-term volatility. But they don’t.
Loss aversion by age
Source: Blake et al. (2019)
And this effect is driven by more immediate needs than saving for retirement. Younger people have lower-paying jobs and fewer savings to fall back on, so they are much less likely to take on financial risks than older people with more savings and more established careers. This is obviously, particularly pronounced in the age of the gig economy and rising inequality. And it will likely be even worse after the Covid-19 crisis than before it because many of the young will be not only restless but increasingly fearful of their future.
Unfortunately, we need these young people to be restless but not fearful because those are the people who can take a risk and start a business. And while most of these ventures will fail, somewhere amongst those young people is the next Bill Gates and Steve Jobs. And if we do not find them, our future will see less technological progress, lower productivity growth, lower living standards, and increased financial security for all.
It is paramount for the economy and all of us that we help younger people overcome their risk aversion by providing them incentives to take on measured risks. At the moment, the only safety net younger people can fall back on is the bank of mom and pop and the national welfare system, but as trial after trial of Universal Basic Income has shown, it encourages entrepreneurial activity amongst the young, especially if they come from a less wealthy background.
And for those who do not like UBI because it smells of socialism, let me suggest introducing government-sponsored venture capital backing as it exists in Israel and Finland. Basically, the more developed the venture capital and angel investment world is in a country, the more dynamic an economy becomes. Countries like Germany or France have relatively small venture capital markets compared to the UK, while the US has a much broader and deeper bench of angel and venture capital investors than any country in Europe (except Israel). According to Statista, Israel spent $414 per capita in venture capital investments, outpacing the United States ($282 per capita) and the UK ($129 per capita) by a wide margin. But the situation is very dire in Germany ($58 per capita) and China ($20 per capita) where the venture capital scene is much less developed. Given these numbers, is it surprising that most of the young entrepreneurs in the key industries of the 21st century (IT, communications, biotech) come from the United States or Israel?