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Consider risk

Lesson in Course: Investing basics (beginner, 7min)

The future is filled with uncertainty. How should we think about risk when investing?

Eureka!

What it's about: Risk is often viewed as the chance an investment will lose money.

Why it's important: Whenever investments go down, we need an even larger percent gain to offset the loss.

Key takeaway: Manage risk by picking investments that fit our risk tolerance and diversifying those investments. 

Risk is often considered as the likelihood of something unplanned or unexpected occurring. Uncertainty can be uncomfortable because it means less security and safety.

For investors, the way we perceive risk is the chance that our investments will go down in value. However, risk is necessary for investing since we can't make a return without taking risks. In general, we can expect a higher return if we're willing to take more risk.

The pain of losing

To learn the strategies that mitigate risk, let's dive into how we think about risk and what losses mean for our investments.

Losing money has negative psychological effects

Loss aversion

Two psychologists, Daniel Kahneman and Amos Tversky, studied how people make decisions. Their experiments lead to the principle of loss aversion.

What is Loss aversion?

Our preference is to avoid losing over gaining the same amount 

The pain of losing $300 is more powerful than the pleasure of winning $300. Our natural tendency for loss aversion can drive us to make poor investment decisions. For instance, if our stock fell on a given day and we sold it simply out of fear that it will continue to fall.

The Downside cuts deeper

The first two investing rules from the legendary investor, Warren Buffet:

Rule Number One: Never Lose Money. Rule Number Two: Never Forget Rule Number One.

Losses hurt more than we think

There is some mathematical truth to loss aversion. Whenever our investments go down, we need an even larger percent gain to offset the loss.

We are actually worse off if our investment goes up and then down by the same percentage.

50% Gain followed by 50% loss example

Let's say we start with $100. Our investment goes up 50% in the first year, and then down 50% in the second.

Year 1: $100+ 50% x $100 = $150

Year 2: $150 - 50% x $150 = $75

We did not break even. We are down $25 compared to where we started despite going up and down the same percentage.

 

Unfortunately, the math shakes out the same way even if our investments fall and then rise by the same percentage.

50% Loss followed by 50% gain example

Similar to before, we'll start with a $100 investment. It goes down 50% in the first year, and then up 50% in the second.

Year 1: $100 - 50% x $100 = $50

Year 2: $50 + 50% x $50 = $75

We can see that the outcome of down 50% followed by up 50% results in the same outcome as the previous example.

 

How much is too much risk?

Every investment has its own set of risks to consider before investing, some being riskier than others. Our risk appetite varies widely from person to person.

Taking measured risk helps prevent panicked decisions
What is Risk tolerance?

The amount of risk we are willing to take

How much we can handle often comes down to managing our emotions, especially when responding to loss aversion. If our investments cause us to lose sleep and give us anxiety, then we've taken on too much risk. We need to make sure we can keep making rational investment decisions to avoid making mistakes.

There are other factors to consider as well. The amount of money we have and time until we need the money from our investment also play into the amount of risk we should take. Having a shorter time horizon or needing the invested money means we should seek lower-risk investments.

What is Risk aversion?

A tendency to prefer investments with lower uncertainty (lower risk) to investments with high uncertainty (high risk), even if the possible gains on the high-risk investment were significantly higher

An example is when a risk-averse investor puts money into a bank account rather than investing in the markets. The bank account provides a low, but guaranteed interest rate compared to a stock with higher expected returns but has a chance of losing value.

 

Actionable ideas

You can mitigate the short-term risks from daily changes in prices by being a long-term investor. The stock market's value might go down on any given day, but if you wait long enough, it will continue to rise over the long term.

You can also lower the chances of losing money by diversifying your investments.

Lastly, if you are unsure about investing and don't think you can manage the emotional aspect, there are professionals that help. Robo-advisors do all of the investing for you, so you can kick back and check in a couple of times a year. There are no shortages of financial advisors that would be happy to help you out with a more personal touch.

Supplementary materials

Watch this video for more depth on how we might think about risk and investment uncertainty
https://youtu.be/TETSZeSoAlk

Glossary

What is Loss aversion?

Our preference to avoid loss over gaining the same amount. The pain of losing $300 is more powerful than the pleasure of winning $300.

What is Risk tolerance?

How much risk we are willing to take.

What is Risk aversion?

A tendency to prefer investments with lower uncertainty (lower risk) to investments with high uncertainty (high risk), even if the possible gains on the high-risk investment were significantly higher