The Psychology of Money 187it seemed like a simple task. By using interviews and questionnaires, they
could construct a risk prof ile for each investor. The trouble is, people’s
tolerance for risk is founded in emotion, and that means it changes with
changing circumstances. When the market declines drastically, even
those with an aggressive prof ile will become very cautious. In a booming
market, supposedly conservative investors add more stocks just as quickly
as aggressive investors do.
A true picture of risk tolerance requires digging below the surface
of the standard assessment questions and investigating issues driven by
psychology. A few years ago, in collaboration with Dr. Justin Green of
Villanova University, I developed a risk analysis tool that focuses on
personality as much as on the more obvious and direct risk factors.
Summarizing our research, we found that propensity for risk taking
is connected to two demographic factors: gender and age. Women are
typically more cautious than men, and older people are less willing to
assume risk than younger people. Looking at personality factors, we
learned that the investor with a high degree of risk tolerance will be
someone who sets goals and believes he or she has control of the envi-
ronment and can affect its outcome. This person sees the stock market
as a contingency dilemma in which information combined with ra-
tional choices will produce winning results.
For investors, the implications of behavioral f inance are clear: How
we decide to invest, and how we choose to manage those investments,
has a great deal to do with how we think about money. Mental ac-
counting has been suggested as a further reason people don’t sell stocks
that are doing badly: In their minds, the loss doesn’t become real until
they act on it. Another powerful connection has to do with risk. We are
far more likely to take risks with found money. On a broader scale,
mental accounting emphasizes one weakness of the eff icient market hy-
pothesis: It demonstrates that market values are determined not solely
by the aggregated information but also by how human beings process
that information.
THE PSYCHOLOGY OF FOCUS INVESTING
Everything we have learned about psychology and investing comes
together in the person of Warren Buffett. He puts his faith in his