Got Risk? Get Over It!

risk-taking

Risky move or human ‘bridge’?  It is how we see it.

“I would like to avoid risk as much as possible” is what we often hear or even say.   That’s understandable for a conversation but the attitude we show towards risk is the single largest determinant of our success.   And that attitude was likely formed even before you entered your teenage years.  There could be any number of triggers for it. 

What shaped your views on risk?

It might have been a crumpled $5 bill that you lost on the way to school, and got an earful from your mom.  Or a $1 wager that you painfully lost with your school classmate for a wrong answer.  Or simply your dad telling you that you have to be very careful with your money and trust no one, not even a bank (or especially the bank, as I was told by a family member once!).   Or you heard some distant uncle lost ‘all his money’ in the stock market and made a mental note to go nowhere near it.  

My uncle, the first one in my extended family to buy a car 4 decades ago, was also the only one in my family who used to ‘dabble’ in stocks and was the de facto investing guru for our entire extended family.   Be afraid, be very afraid of stocks is what my uncle used to tell me. It took me better part of a decade to overcome that conditioning!  

Our attitudes on money and investing are formed very early.

In his delightful book, A Zebra in Lion Country, Ralph Wanger puts it quite well:

Are you a zebra among lions?

Are you a zebra among lions?

“The truth is, we all have an investment philosophy, even if we don’t know it.   In general, it was formed by the time we were out of the sixth grade. Because the main question the investor has to ask himself or herself is ‘what is my attitude towards risk’ and that probably hasn’t changed since you were twelve years old.”  

This is a kick-ass book (couldn’t help the rub-off from my millennial niece who visited us over the weekend!), worth having in our personal library, and off the beaten track of ‘standard’ personal finance books.  Ralph Wanger (who made a lot of money for his investors in his Acorn mutual fund) encourages you to think for your own and identify trends (some visible even now) that can shape the future of the world.  In the process, you will find the next 100-bagger company (where $1000 invested turns into $100,000 over 5-10 years).   Mr. Wanger is listed among the greatest investors.

After my previous article mentioning my 100% stock portfolio, I got some private mails with questions on risk tolerance.   We also saw earlier about a bias that we all have, which also influences our risk tolerance.  Similarly, there is a feeling – at the gut level – we all have about the prospect of loss, which defines our attitude towards risk.

Let’s play a game, shall we?
I love this game!

I love this game!

I will flip a coin 50 times.  For each coin flip, you bet $10 on either Heads or Tails.  If the flip turns heads, you will be paid $25 and if it turns tails, you will lose the $10 that you bet.  You must place your $10 bet at the beginning of every coin flip, so you will be betting a total of $500.   No magic trick here, the coin is a standard government minted one.  There is a 50/50 chance of either heads or tails showing up.  

Think about this honestly – will you play this game?   Cue Jeopardy music….

Most people will not.

That’s because they are worried about the possible loss.  Psychologists call this human behavior as ‘loss aversion‘.  Our attitude towards this game will tell us a lot about our risk tolerance and investment attitude.

risk loss profit blocksOn the other hand, no Las Vegas casino will offer this game because they will go bankrupt if they do! A casino only offers games where the house always wins but here, the house is bound to lose because the expected outcome is always positive for the player. This game is totally rigged in your favor and yet, most don’t play! Knowing that heads is the winning bet, you can bet heads all the way, and if the odds play out 50/50 as expected, you will walk away with a profit of $125!  In math, this is called ‘expected payoff’ because you are expected to make a profit of $125 in this game (0.5*50*$25 – 50*$10).  In percentage terms, your profit is 25% in this ‘investment’ because you bet $500 in total and are most likely to walk away with $625 ($125/$500 = 25% profit).

I can hear some of you thinking, this only sounds good Mr. TFR, what if my luck is so bad that I get 40 tails or even 50 tails?  You will lose money then. It can happen but the odds are unlikely.  

Between 1970 and 2015, the US stock market was up 34 out of 45 years. That’s 76% of the time period.  Even if the stock market is up 76% of the time, if you suffer losses three years in a row, you will be bummed and won’t have the patience to stay invested to recoup your losses when the inevitable rise happens. The problem is of faith and total risk avoidance.  Many are unable to stomach even the very low chance of losing money in a game so clearly rigged in your favor.  This is the power of loss aversion.  This is what Princeton economists Daniel Kahneman and Amos Tversky discovered in 1979. 

Some psychologists conclude that most humans are wired in such a way that a potential gain must be twice or more than a possible loss – only then we make our bet.  So, in the coin toss game, if you were paid $60 for heads, most of you will agree to play this game (because the expected payoff will be $1000, which is twice the $500 bet).  Such games are, unfortunately, not easy to find in real life. 

Unless we understand expected payoffs and deal with calculated risks of any financial decision, we will not have the guts to be a successful investor. Otherwise, what we learned about risk as a 12-year-old will stop us from growing, both professionally and financially.

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6 comments on “Got Risk? Get Over It!”

  1. By ann

    Funny, maybe it really is a problem with learning math! I am not at all good with numbers and can mix them up or forget them, but living with my numbers man husband has taught me to pay attention and use numbers/math better. I quickly ran the numbers and was going to take your bet, but I wouldn’t have 15 years ago , because running the numbers was not natural for me.

    Another funny, my great great grandfather dabbled in the stock market too and bought on margin before the great crash. My grandmother was deathly afraid of stocks, because of it. As she and I watch a show on the stock market, she finally realized that her grandfather had been taking a foolish bet. She didn’t invest in the stock market, but I learned not to be scared of it. I also learned not to only put 10% down on a risky venture! Of course, this same man bought yearling cattle at a high price, when they died from hoof and mouth disease, he bought more at a higher price……you can see where that went. Unfortunately, he died in an accident with no life insurance a few months after the cattle died. Maybe the stock market was not really at fault for his loss? I just planned to learn from his mistakes.

  2. By ZJ Thorne

    I was definitely afraid of loss before I started investing, but my biggest fear was being illiquid since my job is contingent and I had opened a business. Once I felt that my liquidity would carry me through, I opened an IRA and answered the questions in such a way that my risk profile is high enough for the Retirement Date Portfolio robots to have me in 92% stocks. In my brokerage, I am fully stocks by way of index funds and some individual stocks I’m learning from right now.

    • By TFRadmin

      ZJ, Risk tolerance, like learning a bike, comes by slowly. Once you learn to balance and make the tight turns using the bike, then your risk appetite for owning stocks goes up because you understand volatility is not the real risk. Like bike riding, you may fall occasionally and get scrapes and bruises (eg, investment losses, speculative stocks, yield chasing etc as I have done) but you learn from these and become stronger. Good luck in your 10! Journey.

  3. By Matt @ Optimize Your Life

    This is a really good explanation of loss aversion and its impact on investment strategies. The Kahneman and Tversky studies are helpful for figuring out why we tend not to act in our own best interest.

    Sadly, I think most people do not take the time to think this through rationally. They have in their heads that they could lose their money in the stock market and so they don’t bother researching any further. You are completely right, though, that people need to be looking at calculated risks if they want to be successful investors.

  4. By The Green Swan

    Those are interesting studies on loss aversion… But it’s also pretty compelling knowing the stock market goes up three out of four years.

    I’ve tended to be an optimist so have had no qualms about investing my portfolio entirely in stocks. It was painful after 2008 and I was nervous about future losses, but fortunately I stayed in the market and ended up making my money back quickly. That was a valuable lesson for me to experience and learn!

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