About Risk
Risk tolerance, loss aversion, and how feelings about risk get in the way.
The game of risk
Join me on a thought experiment.
Imagine you are sitting at a table. On the table sits a box full of marbles. The lid is closed, but you are told that there are 101 marbles inside the box; 100 blue marbles and 1 red marble. You are asked to reach in and select a marble without looking.
Obviously, the purpose of this exercise is to find the lone red marble. What are your chances of finding it? Even if you have never taken a statistics course, I’m sure you know the chances of picking that red marble is 1 in 101.
Now, stop and think about how you feel about that. Do you feel anyway in particular? Despite the small joy you might experience if you did find the red marble, I doubt you feel any way about it at all. It’s 1 in 101. That’s it. Nothing more.
Raise the stakes
Now let’s add a wrinkle:
· If you pick blue you lose $1, red you win $100
· Blue lose $10, red win $1,000
· Blue lose $10,000, red win $1,000,000
Now we’re talking. Unlike our first example, these situations certainly inspire some feelings. How would you feel if you were presented with these? Perhaps anxiety, excitement, fear? What if you were able to select which one to participate in? Which would you choose? Out of curiosity, I presented these options to my 15-year-old daughter. She quickly agreed to the first and second, but the third was a hard no. Just too much money to lose.
Let’s take a step back and examine these options. Interestingly, the statistical outcomes in each of these examples are exactly the same. They are also the same as our original example, 1 in 101; the same probably as picking a red ball. Further, the payouts and penalties are designed in such a way that, if you played each option infinite times, you will end up winning and losing exactly nothing. It is a neutral offering. Each example is a 1 in 101 chance that evens out over time. They are identical in long term outcome, yet each one feels different than the last. Despite the statistics, the possible outcomes and our feelings about the dramatic wins and losses get in the way of statistics and reason. Statistically we shouldn’t prefer any one of these over the other, yet each one seems undeniably different than the last.
The long term
Let’s think again about the “lose $10,000/win $1,000,000” option. As I imagine most of you would say no to this option, let’s try to change how you feel about it. Let’s assign a goal and think of it over a longer time frame.
Let’s imagine you have $1,000,000 to begin with and your goal is to end with $1,000,000. No, not a very audacious goal, but stay with me. You must end with the same amount you start with but here’s the rub:. 1) you must play at least once each day for a year but 2) you can play unlimited times per day. That’s it.
Does the starting amount of $1,000,000 make the proposition seem more reasonable? Since you’re starting with so much to begin with, perhaps the idea of losing $10,000 stings less than starting with nothing. Also, how does time affect this exercise? You know you will play at least 365 times. Does that help? Since the law of averages is on our side, you would be wise to play as many times as you possibly can. If you do, over time you will land very close to your $1,000,000 goal.
Why this matters
The reason we feel so differently about these examples (despite their statistical balance) has to do with our individual risk tolerances along with a bias known as “loss aversion”.
Risk tolerance and loss aversion are very real and unique to you and your situation. Everyone has a different risk tolerance, and everyone carries different types of biases along the way. In the world of behavioral finance, these ideas are incredibly important. Not surprisingly, they are also just as important in personal finance and financial planning.
Risk tolerance
Your risk tolerance is exactly what it sounds like. It is your ability to tolerate risk; how you feel about it. How do you feel when your investments lose value? How do you feel when your investments are volatile and changing every day?
If daily swells and swoons make you nervous about your portfolio’s performance and stability, you might have a lower risk tolerance. If this is the case, you probably prefer slower, more stable growth compared to investments that provide faster, more volatile gains (along with the greater chance of loss).
If you would gladly play the $10,000/$1,000,000 challenge and not lose any sleep over the daily fluctuations, then you probably have a higher risk tolerance. People with high risk tolerances are typically more confident in the probable outcomes of their investments over the long term. These individuals expect higher returns for their acceptance of volatility and are willing to ride out the ups and downs.
If you’re curious, here is a free, brief questionnaire to get an idea of your risk tolerance.
Note: Risk tolerance is not the same as risk capacity. While risk tolerance focuses on attitudes and feelings, risk capacity measures your actual financial ability to absorb risk (regardless of your feelings).
Loss aversion
Loss aversion is a type of financial bias that defines a person’s disproportionate fear of loss when compared to their satisfaction in gains. Simply put, someone with loss aversion fears the chances of losing over the possibility of winning, even when odds are on their side.
What if we doubled the “win” side of our $10,000/$1,000,000 and made the red marble prize worth $2,000,000? Does this sound better?
Mathematically speaking, this is a guaranteed win. Over time, you would pocket an average $1,000,000 for every 101 times played. Is it practically a sure thing. However, even given the statistical facts, someone who suffers from severe loss aversion would still hesitate to participate in this exercise. The idea of losing multiples of $10,000 is just too much to deal with.
Potential outcomes change everything
To better understand how loss aversion feels, let’s change the stakes.
· Blue you win $100, red both your eyebrows are shaved off.
· Blue you win $10,000, red you lose an arm.
· Blue you win $1,000,000, red you age 40 years.
Not only do these propositions feel dramatically different than our original example, they feel completely incomparable. Now instead of a 1 in 101 chance of winning, you have a much improved 100 in 101 chance. However, the outcomes are wildly different.
Interestingly enough, my daughter still agreed to the first proposition. “After all,” she said smugly, “women shave their eyebrows off all the time.” Despite her quip, she was still a hard no for the other two. The chance of the drastic losses was too much for her to bear, even given the small chance of it happening.
This is how loss aversion feels. Even with the near certain chance of winning (over 99%), the uncomfortable or unbearable idea of embarrassing or tragic loss would make even the most reasonable person pause. To illustrate my point, think back to when you had a 1 in 101 chance of winning. Did you feel winning was somewhat unlikely? What about with the extreme loss examples? In these exercises, the chances of losing were the same as winning before; 1 in 101. However, the gravity of the loss makes that 1% chance feel terrifyingly likely.
How to navigate risk
So, given our personal feelings about risk, our varied risk tolerances, and our associated biases, how do we deal with risk?
In my book, “Principles of Prosperity”, I talk about the importance of creating value centric goals. In a nutshell, value centric goals are created around what matters to you the most. Once you determine your values and curate goals around them, you can create a plan to make your meaningful goals a reality.
These types of plans typically involve setting aside some amount of money every month and estimating how much you need that money to grow. The determined growth needed to achieve your goal is how we determine what type of investments are required to match the return. Here is where the risk comes in.
In investing, risk and growth are directly related. That is, the more growth is required for your goals, the higher the risk that must be assumed. To put it another way, the more risk you assume in your portfolio, the greater the returns you should expect.
Once you have a goal that is grounded in your values, the associated risk will hopefully seem much more palatable. It should be seen as the necessary cost of achieving your goals. After all, instead of suffering through needless volatility, you can rest assured that the risk is simply part of achieving a goal that is based on what is most important to you; your values.
Know yourself
Despite knowing how much risk is necessary to achieve your goals, risk tolerance is still very real. You’re the one that has to deal with the ups and downs each day, and some days will be easier than others. Perhaps the risk associated with a 10% return is simply too much for you to handle. If so, you should consider investing more money per month with a lower required return (and lower risk). Also, you could scale back your goal in order to make a lower return possible. After all, you are the one that has to live with the risk in the meantime. You’re also the one that has to live with the results in the long run.
Once again, take this questionnaire to discover where you stand when it comes to risk. Also, book a discussion with me if you have any questions. As always, the first meeting is free.
In the end, risk is fertile ground
Risk is inevitable and ever present. It is a necessary part of any worthwhile investment and can cause panic, fear, and regret over the short term. However, risk is also the friction that makes growth possible. Within the risk and volatility of the market lies the chance for almost certain growth over the long term.
Your feelings about loss and risk are valid and present. However, once you develop your values, goals, and a plan to achieve your prosperity, don’t let risk stop you. Create value centric goals, make a plan, embrace the risk associated with your dreams, and carry it confidently along the way.
