Got Risk? Get Over 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?
“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 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.
On 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.
Originally published at tenfactorialrocks.com on September 1, 2016.