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.
Two psychologists, Daniel Kahneman and Amos Tversky, studied how people make decisions. Their experiments lead to the principle of loss aversion.
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.
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.
Unfortunately, the math shakes out the same way even if our investments fall and then rise by the same percentage.
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.
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.
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.
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.