Behavioral Economics and Finance - What do we mean by Risk Tolerance

What do we really mean when we say “risk tolerance?”

Discussion about the suitability concept in the regulation of securities transactions frequently focuses on the “risk tolerance” of an investor/client.  If risk tolerance is defined on a subjective basis, that is, what is the actual psychological risk tolerance of this client and not what should it be (the objective basis) then perhaps the risk tolerance would change depending on changes in the mental outlook of the client^*. If that is the case …

*   I googled “define risk tolerance” and came up with an abundance of definitions. Of those which addressed the definition in the context of investing I would estimate that a slight majority simply assumed a subjective orientation and the remainder addressed it in terms of an objective standard.  Not one addressed this issue head on.  There are many scholarly articles which recognize the distinction and suggest ways to overcome an “inappropriate level of risk aversion” (or subjective risk tolerance) but they do so in connection with an analysis of the acquisition and maintenance of an objectively appropriate portfolio and do not discuss the issue at hand. I suggest that the question I posed at the beginning of this Observation is important and especially so in the context of dispute resolution.

…then what follows may be important.

·        Paul MacLean

            Please excuse the length of this Observation.  In past Observations I have identified certain components of the brain and discussed how the brain uses them to confront and resolve economic dilemma.  I would like to dig just a little deeper on this subject because I think it is critical to have a basic understanding of brain anatomy and function if you are to separate yourself from the pack.  So with that here goes….

The era of the development of classical economic theory took place before the development of modern neurological science and theory.  Economists (and others) during that era believed that the cognitive portions of our brain dominated the non cognitive portions of our brain thus controlling our economic behavior.  This belief may have helped to develop two assumptions which underlie much of what we learned about economics and finance. The first assumption is that people make rational economic decisions (think of the concept of utility maximization). The second is that people are unbiased in their predictions about the future.  The utilization of these assumptions probably reached a culmination in the 1950's when Harry Markowitz presented the concept of the "efficient frontier" in connection with what has become known as "Modern Portfolio Theory."

    Over the succeeding decades neuroscience began to demonstrate that which we already knew and that was that those two assumptions (while probably useful in the abstract) were simply and fundamentally wrong¹.  Let me explain.  In 1970 Paul MacLean, a neurologist proposed a (then) novel concept and that was that we have in effect three brains (not one) each with a separate evolutionary chronological history.  Each subsequent brain was built around (indeed to an extent physically wrapped around) and upon the foundation of the brain or brains that preceded it in evolution.  MacLean called this the "triune brain."² His classifications of the brains were (1) the reptilian (consisting of the brain stem and cerebellum), (2) the limbic or paleo - mammalian brain and (3) the neo-mammalian brain (the cortex). These three brains operate much as "three interconnected biological computers, [each] with its own special intelligence, its own subjectivity, its own sense of time and space and its own memory".  Each brain is connected by neural pathways to the others, but each operates as its own brain system with distinct capacities. Further work by MacLean and others have shown that the cortex often does not dominate the other brains but is often overruled in the evaluation and decision making process (frequently by the older limbic system-the one that rules emotions)³.

The first to develop in evolution is the reptilian brain possessed by all animals. It is ancient, basic, rigid and functionally repetitive.  In sum it regulates our involuntary muscles and basic bodily functions such as our breathing and heartbeat.

The second is the Limbic system or for lack of a better description the middle part of our brain.  This portion is possessed by most mammals. It is concerned with regulating emotions and instincts and largely is responsible for our survival from harm.  It includes the hypothalamus, hippocampus, and amygdala.  This system determines, among other things, whether you will have a positive or negative outlook in regard to something and is responsible for your determination of the "relevance" of something you encounter. It also is involved in your determination as to whether the cortex has had a good or bad idea.  The limbic system has vast interconnections with the cortex, so that many brain functions are not either purely limbic or purely cortical but a mixture of both. That, it turns out, is a very important point. Often the Limbic system overrides a conclusion by the cortex.

The cortex and the last "brain" to develop is the seat of cognitive functions and rational thought. It was exclusively here that classical economists thought that economic dilemma were confronted and decisions made.  It turns out not to be the case at all. In previous Observations I have discussed those portions of the brain that are involved and their effect on the evaluation and decision process. If you didn't receive them I can send you a copy.  More importantly, there are many good books and articles dealing with this subject and I would suggest googling "neuroeconomics", "behavioral economics" and "behavioral finance" as a way to find them.

Oh yes, what's my point in all this? Learn the basics of this new body of knowledge and beat out your competitors. 

1. Do you really think that a real live investor’s risk/reward parameters can be described using a quadratic utility function? 
2. Paul D. MacLean, A Triune Concept of the Brain and Behavior: The Clarence M. Hincks Memorial Lectures, 1969, University of Toronto Press, 1973. ISBN 0-8020-3299-03. Paul D. MacLean, The Triune Brain in Evolution: Role in Paleocerebral Functions, New York: Plenum Press, 1990.ISBN 0-306-43168-8.
3. See for example Paul W Glimcher, Decisions, Uncertainty, and the Brain: The Science of Neuroeconomics (Cambridge, MA;MIT Pres, 2003) and Colin Camerer, George Loewenstein, and Drazen Prelec, “Neuroeconomics: How Neuroscience Can Inform Economics,” Journal of Economic Literature 32 (2005):9. For those who prefer to read informative but less academically oriented works, Jason Zweig’s book is a good start