Are Investors Truly Risk Lovers?
There is a pervasive misconception about investors. The achievements of a small group of high-income individuals who take significant risks are often highlighted in the financial markets. They never flinch in the face of great risks and show up in the financial markets with wildly confident mentalities and investment practices. In today’s world of rapidly spreading media coverage, this information quickly reaches the ears of potential investors. These stories and events become role models in the minds of many people for the rest of their lives.
Meanwhile, cinema and TV shows also drove the stereotype that investors are risk-takers. Bobby Axelrod from Billions movie celebrates his role as a hedge fund leader who joins atypical investment techniques to make an extraordinary profit. Applying the financial specifics taken under confidentiality to the casino’s financial troubles, he boldly betted on his short-urging rather than selling the stocks before the market began to churn and return a dizzying amount of money. Ultimately, it is not a way of true investment that he is seeking; he wants to be the wealthiest person in town. As a result, he violates the legal boundaries and ethical principles, which creates unfair competition. Still, this risky and, in some cases, illegal model of virtual investing hardly destroys the prevalent perceptions that investors are those who take pleasure in the excitement of risk and have a high chance of gaining a fortune.
One factor is the tendency to end up with full-entrenched avatars rather than to stay linked with the ongoing reality; on top of that, we know how people love the drama in entertainment programs more than in economic analysis, and therefore, this illusion always accompanies us. While these programs may meet people’s cultural expectations, they often perpetuate a distortion of the nature of the actual investment fields. Gradually, this exaggerated spirit of investment risk-taking converges into a dominant ideology that has influenced society for more than one generation. This misconception has become so deeply ingrained that a genuinely nuanced understanding of the logic behind investing, a primary investment framework, and a robust psychological profile are required if the stereotype is to be flipped. Some risky ventures are often perceived as high-risk, high-reward opportunities, yet they are more accurately classified as gambles rather than investments. Take oil drilling as an example - despite its potential for lucrative returns, it carries significant environmental and financial risks. This illustrates how the pursuit of high risk has become deeply ingrained in most people’s hearts, evolving into a habit and perceived necessity to attain profits. Such a mindset significantly impacts individuals and society at large. People are uncertain as they don’t know where oil is and how much there is. It is like treasure hunting. But if people find oil, the payoff can be huge, like finding a treasure chest of untold value. People take the risk because the potential payoff is high. If they find large reserves of oil, it will bring substantial profits. Investors are attracted to these opportunities because the winners potentially be able to make a lot of money even if they still face the possibility of high levels of uncertainty. However, it is essential to understand that not every oil drilling venture will be successful, so it is a classic example of a high-risk, high-reward investment. It’s not so much an investment as a grand gamble, where you get more if you’re lucky and less unlucky.
Based on the oil drilling example, the notion of risk-averse investors is deeply ingrained in social theory, which refers to the study of how individuals and societies interact and influence each other. However, a closer examination reveals a very different reality. This pervasive stereotype not only profoundly affects public opinion but also has tangible impacts on financial markets. As exemplified by the sentiment captured in the saying ‘Don’t put all your eggs in one basket’, investors don’t necessarily feel secure about their wealth. According to F&G’s Annual Risk Tolerance Tracker (2022), two-thirds of American investors express insecurity about their financial security and investments, reflecting a greater tendency toward risk aversion among the investors. It shows that investors increasingly expect the financial sector, governments, and markets to be more responsible for the stability of personal money and the markets. The public is looking for reliable and risk-free ways to protect the financial interests of millions of individual investors, which means a major shift towards risk-free investment options.
From the perspective of risk aversion, I examine the perceptions and research on risk from the perspectives of ordinary people and professionals, revealing the significant impact that risk aversion has had in shaping economic growth and influencing market dynamics. Risk aversion in the general population may be due to a combination of factors. First, the lack of interest in financial and economic development leads to a lack of awareness of financial markets and investment options. Furthermore, even interested investors often lack the resources to obtain complete and accurate market information, which sets up a risk-neutral perspective. Besides, misconceptions about market performance and a limited understanding of how data functions can give rise to a general fear of investing, causing individuals to favor low-risk investments. Finally, without proper financial education and guidance, individuals may struggle to make informed decisions about investing. Once there is a great deal of uncertainty and hesitations, people are reluctant to make difficult or non-essential decisions. All these factors can lead to people being risk-averse from the surface. This relatively negative (don’t know how to do or don’t want to do) risk aversion has specific impacts on the market, such as leading to financial illiteracy, reducing the liquidity of funds, abnormal fluctuations in stock prices leading to market inefficiencies, etc. To shift from a mindset to a positive and proactive investing environment, individuals can participate in a self-directed learning process to improve their knowledge and understanding of investing, like “The Plain Bagel” channel on YouTube, “The Indicator from Planet Money” on NPR podcasts, Coursera courses, etc. This educational process can help individuals transition from fear or panic to a more confident and assertive approach to investing. How about relatively positive risk-aversion (already lowering or still learning to lower the risk) investors’ logic and approaches when investing?
Imagine losing $100 or gaining $100, which is more memorable? Most people would find it easier to remember the pain of losing $100 than the joy of gaining $100. This behavioral trait may lead investors to want to reduce risky investments because they may be more concerned with avoiding losses than seeking higher returns. This attribute often makes investors want to reduce their investments in risk since they may now consider reduction of losses more important than seeking gains. First, this type of investor doesn’t have to worry about fluctuating income, as the bonds provide more stable income. In addition, they can’t risk losing their principal, so they prefer more secure investment options that the bond market offers this means that investments that previously were realized only through high-risk strategies and bearings can be done in a bidder-like fashion now. Many choose lower-risk efforts like certificates of deposit (CDs), treasury and municipal bonds, or dividend growth securities as their portfolios. These opportunities are proposed to safeguard capital values and to ensure investors who like the stability that they get a fair trade in return. According to a recent survey, a significant portion of American investors have become more risk-averse. Specifically, the percentage of Americans who reported increased financial risk aversion grew from 69% in 2021 to 78% in 2022 (F&G Annuities & Life, 2022). This indicates a clear trend towards higher risk aversion among investors over recent years.
CDs from the institutions, that banks hold, are locked in at a fixed rate and given maturity dates (Fernando, 2023). They are called conservative investments maintained up to a certain amount of money and guaranteed by the federal government. With assured profit, risk-averse investors tend to prefer CDs. My mom did not bother investing because there were factors she could not depend on, which could lower her living standard. Nevertheless, I showed her the CD opportunities offered by savings banks such as BOA, Chase, and University Credit Union, and she learned about their short-term exchange rates as well as minimum limits. She discovered that she could profit by keeping the money in the bank for some time without doing anything else. For her, it was just pennies, a way of contributing to the family income.
Another purchasing strategy that is helpful to investors is bonds or debts issued by the government at different levels of authority since they have a strong credit hold and the possibility of default or abstaining is low. It should be noted that federal government bonds are debt instruments issued by the federal government to raise money. However, these bonds are highly trusted because it is the only debt security the federal government can 100% rely on unless the government decides to increase the tax or print currency. The federal government can do those things without facing the problem, and the credit established has been around long enough to hold quite a high credit rating. In contrast, municipal bonds is that they are issued by cities, villages, or states with an exemption from federal income and property taxes which also becomes the reason that the total yield to the investors is at a higher level. They have even higher credit ratings compared to corporate bonds due to their low rates of default in the past (>0). According to Goldman Sachs (2023), the average U.S. household holds just 2 percent of Treasuries in 2022, growing to 9 percent in 2023. The rise in the percentage of households holding Treasuries may indicate a growing preference for safe and stable investments among investors.
Dividend growth shares are one of the oldest types of investments. They are not volatile and pay a particular portion of profitable income to investors who usually do not hope for huge revenue growth but for long-term consistent income, which will later increase their total return. However, given dividend payments, which do not increase the shareholder’s value of these stocks, they can safely be owned even by investors whose risk tolerance is low. These dividend payments can supplement investors with low-risk tolerance or can be reinvested within the company itself. Although dividend growth stocks might not be as safe as deposit certificates of federal securities and high-yield municipal bonds, they are increasingly gaining popularity among risk-averse investors for their balance of risk and potential reward. Besides dividend- paying stocks being friendly to beginners and intermediates, billionaires always keep their eye on dividend growth stocks as their outperformance and stability over non-dividend stocks (yahoo, 2023). This behavior shows that these mega projects with high-growth potential that billionaires take on have a risk reduction focus alongside the profit maximization strategy.
How about Buffett, Oracle of Omaha? Many investors may be perplexed by Warren Buffett’s ability to generate long-term profits, given his reputation as a high-risk, high-reward investor. Some examples of Warren Buffett’s classic “risky” behavior include his investments in tech companies like IBM and Apple, which were seen as departures from striving for success through a stable approach. Additionally, his acquisition of struggling companies such as Coca-Cola in the 1980s and Bank of America during the financial crisis were perceived as bold moves that carried significant risk at the time. However, upon closer examination, it becomes clear that his investment strategy and philosophy are not as risky as they may seem. After analyzing the status of his investment targets over different time periods and examining the number of shares he holds and the duration of his investments, it becomes evident that Buffett’s risk management techniques are not solely focused on chasing high-risk opportunities. Take his “margin of safety” move — it’s all about investing in companies when their market value is much lower than their true value. It’s like looking for coupons before you shop to see if there’s an opportunity to save money. Moreover, Buffett avoids hasty profits and instead chooses to invest for the long term, not because he cannot make huge profits in the short term, but in order to minimize the huge short-term risks of uncertainty. His “buy and hold” strategy requires him to hold his investments for the long term, allowing the returns to grow gradually over time. This approach is characterized by patience, forethought, and intentional avoidance of business-related risks, which are absorbed by the business in the short term. Notably, Buffett is indifferent to changes in broad market trends. While the latest industry trends attract other investors, he has always followed basic investment principles. The criteria he seeks to invest in prioritize a company’s actual value (rather than stock value), operational efficiency, and sustainability potential. This disciplined approach focuses more on the essentials than the glitz and glamor. Known for his commitment to investing fundamentals, Buffett underscores the significance of prioritizing these core elements over superficial appearances.
Integrating artificial intelligence (AI) into the investment decision-making process has generated considerable excitement, yet the academic and financial communities have maintained an attitude of concern. While proponents speak highly of AI’s revolutionary potential for data analysis and predictive modeling, the practical application of AI to investment risk management reveals a complex and challenging reality. AI-driven tools are lauded for being able to process massive amounts of data, identify complex patterns, and predict market trends beyond the reach of humans. However, AI’s potential has also exposed its vulnerabilities, particularly in bias and inaccuracies in algorithmic decisions. As a groundbreaking study conducted by the US Securities and Exchange Commission (SEC) reveals, the AI models used by financial institutions are biased, leading to inaccurate risk assessments and poor investment strategies (Boukherouaa, 2023). Buffett’s caution reflects widespread concerns about over-reliance on AI for investment decisions. He stressed the importance of retaining human intuition and skepticism to balance AI’s analytical capabilities with the need to judiciously judge its output (Speights, 2023). In addition, the opaque nature of AI systems poses another challenge, as it is difficult for investors to understand how AI generates recommendations, especially when markets are volatile. While it may be difficult to find specific examples of AI-driven investment failures in the current literature, the hypothetical scenario highlights the inherent risks of blindly trusting algorithmic decisions. Wrong stock selections, inaccurate risk assessments, and inadequate responses to market volatility are all cautionary examples that prompt a sober reexamination of AI’s role in investment risk management. In summary, while AI has great potential to transform investment strategies, its effectiveness still depends on addressing challenges and constraints in algorithmic decision-making. Therefore, in the complex environment of navigating investment risk management, it is critical to balance the analytical power of AI with human judgment.
In light of this, it becomes evident that individuals deeply versed in investing, such as Buffett, play a pivotal role in market dynamics. They help stabilize markets by making relatively prudent decisions and avoiding impulsive actions due to short-term volatility. These investors take a long-term view and focus on the underlying value of assets rather than instantaneous profits. Their prudence also cushions speculative behavior and promotes prudent investment behavior and efficient capital allocation. Through an informed and highly strategic approach to investing, these investors promote a market culture that values sound fundamentals and personal analysis over blindly following market trends. Ultimately, they create a stable, informed, and rational market environment.
In conclusion, it is crucial to challenge the underlying assumption that investors are inherently risk-takers. The investment situation and logic still need to be understood by more people now. Risk-averse investors play an important role in shaping financial and social stability and, as such, are exemplary for people to accurately understand market behavior and make informed decisions in an economic environment. Thus, recognizing investors as risk-averse serves as a cornerstone for navigating the complexities of the economic landscape and fostering sustainable growth.
Work Cited
Boukherouaa, G. S. B. (2023, August 18). Generative Artificial Intelligence in Finance: Risk considerations. IMF. https://www.imf.org/en/Publications/fintech-notes/Issues/2023/08/18/Generative-Artificial-Intelligence-in-Finance-Risk-Considerations-537570
Chen, J. (2023, April 30). Risk Averse: What it means, investment choices and strategies. Investopedia. https://www.investopedia.com/terms/r/riskaverse.asp
Explore the 2022 Risk Tolerance Tracker | F&G. (n.d.). https://success.fglife.com/risktolerancetracker
Fernando, J. (2023, November 28). What is a certificate of deposit (CD) and what can it do for you? Investopedia. https://www.investopedia.com/terms/c/certificateofdeposit.asp
Speights, K. (2023, June 19). Warren Buffett Is Worried About AI. Here’s How He’s Betting Big on It Anyway. The Motley Fool. https://www.fool.com/investing/2023/06/19/warren-buffett-is-worried-about-ai-heres-why-hes-b/
Two-Thirds of American investors feel like their financial safety net has been taken away, finds F&G’s annual Risk Tolerance tracker | F&G. (n.d.). FGLIFE.COM. https://www.fglife.com/news/annual-risk-tracker-2022
Yahoo is part of the Yahoo family of brands. (n.d.). https://finance.yahoo.com/news/treasury-bond-buyers-increasingly-households-225615608.html?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAAFalPFwR_VAvtqajRN2yRIhWOFp-DwueakGTsJYLut5YdFniVSKku_yNpTWvBgN8e04wiblhaxcgD7sXIeAZ16FUePh5sleIQKMsFq2IwgNBdzXhyS5beJStewbhAZZqyxtcHEhYxuh2nW3HYip6nG2bfm0mFs_A_Uo8PAnp9ntk
