Chicago psychologist Ken Celiano sat down recently with a commodities trader who had enjoyed a long, successful career in the pit. But market modernization had sent him home to trade by computer -- and suddenly everything was going haywire.

"You could see it when you walked in the door," Celiano says. "He was cooped up in an office, smoking cigarettes, agitated, pacing. There was chaos in his personal life, fueled by the chaos in his financial life."

To recover the lost sense of action in the pit, the trader had switched from strategic investing into a gambling mode. And over the previous six months, it had cost him $700,000. When gut moves aren't enough

Any personality questionnaire would have classified this guy as built for financial risk taking, no matter whether he was shouting across a crowded trading pit or sitting alone at his computer. But that's part of what's wrong with investor-risk profiles: They don't take into account changes in circumstances. For this trader, although the dollars at stake remained the same, the new solitary nature of his job had left him hungry for more action.

Risk questionnaires assume tolerance for risk is a more or less fixed personality trait, a product of genetics and upbringing. And science has recently turned up some evidence supporting this idea. In some people, the parts of the brain that help us move forward in the face of risk -- notably the ventral medial prefrontal cortex and the hippocampus -- are larger and more robust. Levels of the neurochemicals that influence the ability to handle risk can also vary widely from person to person, and those may have a genetic basis.

But in the real world, "people's attitude toward risk is extremely unstable," says Nick Chater, a cognitive scientist at University College London. It all depends on context: A race-car driver who routinely puts his life on the line at the track may be terrified when it comes to investing his winnings; a high-stakes mergers-and-acquisitions deal maker may turn to mush when you put him in a sailboat.

Even experienced investors can drastically change their approach to risk depending on whether they've been winning or losing. "Survival of the richest"?

Chater studies what he describes as "a strange phenomenon called 'prospect relativity.'" In short, it suggests that people are basically clueless about evaluating trade-offs between risk and return. Instead of having an objective standard, they judge risk and return largely based on what they've been thinking about lately. For instance, if we've been losing small change playing the slots and then suddenly drop $20 on a hand of blackjack, that can ruin the night for us. But it may not faze us at all that our stock portfolio was up $2,000 yesterday and down $1,000 today.

"Our psychological makeup doesn't give us any machinery for comparing the level of risk" from one part of our lives, or even from one part of our finances, to another, Chater says. Instead, we take shortcuts.

For instance, maybe you categorize yourself as a moderate-risk investor. So if you're looking at a group of tech stocks arranged from lowest to highest risk, 1 to 10, you might choose No. 7. And in a range of blue-chip stocks, says Chater, you're likely to go for No. 7 again -- because that seems like the moderately risky choice, relative to the other prospects at hand. But this shortcut may not get you where you think you're going. If you actually sat down and did the hard work of thinking through the risks and rewards, Chater says, the moderate-risk choice might be the No. 2 stock among the highly volatile techs and the No. 10 stock among the plodding blue chips.

Sound hard? It gets worse.

"You really need to be considering the range of risks you're taking across your entire financial portfolio," Chater says. "Therefore, you have to make comparisons between the risk in your housing, the risk to your labor assets, the risk to your stocks and indeed probably other risks as well -- the risk to your life, to your health and so on."

Chater concedes that such comparisons are hard to make. Moreover, the acceptable level of risk can vary from one area to another: People who would never borrow to invest in stocks routinely do so to buy a house, and with good reason. Even so, Chater says, it is "absolutely crucial" for investors to make such comparisons to arrive at "a coherent set of behaviors" that serves their interests. Quiz: How much of a risk taker are you?

The comparison process might alert you, for instance, not to tie up a large part of your money in your employer's stock. That kind of risk overlap -- with both employment status and stock investments tied to a single company's fortunes -- proved devastating for employees at Enron, WorldCom and other failed companies. The global view of risk might also tell a young investor to stop worrying about stocks for now and redirect the money and the attention into career development, because that's where the biggest potential rewards lie. People, says Chater, "can spend an awful lot of time optimizing things which aren't actually very important."

So does that mean the risk-profile questionnaires used by many financial institutions are useless? They're at least a good way to get investors to start to think about risks and rewards, according to Chater.

But they're only a start.

Published Feb. 25, 2008