Risk Aversion – What is it?
A common question and one that has compounding effects on your investments. So, what is it?
Google “risk aversion” & the top 3 articles easily explains its fundamental basics. Of course, diving into the deeper end unveils further discussions on game theory, risk neutrality, risk acceptance etc.
That said, let’s keep it simple! After all, this isn’t meant to be a masterclass on the essentials of finance. At Seedly, we’re here to break it down for you, sprouting the seeds of knowledge.
Yes, lousy pun intended.
TL;DR: Distinguishing Risk Attitudes
Investopedia defines risk aversion as characteristically choosing an investment with lower risk versus one with higher risk and similar expected returns.
Risk averse investors can simply be thought of as individuals who avoid risks within their sphere of control, usually opting for safer investments that promote stability in the long run.
Devilishly Spicy – What McSpicy taught me about risk
A common example found in finance literature references one’s desirability functions to the probabilities of gaining a coveted good.
In the next 2 minutes, I’m going to attempt to break this down into layman terms – specifically, leveraging on my love of McSpicy.
Ever walked into McDonald’s, contemplating the consequences of your next McSpicy order? Well, I have. You’ve heard the stories – the impending toilet runs faced by McSpicy connoisseurs islandwide followed by the sweltering heat – begging the question, why can’t we stay away from it?
Glorious, delicious, tongue tingling McSpicy goodness.
Risk Averse versus Risk Seeker
Imagine being offered a guaranteed payment of $100 or a chance at receiving $200. However, you risk receiving nothing by opting for the $200 bet. How would you react?
Think about it this way –
- Would you avoid ordering a McSpicy for fear of the possible consequences?
- Would you double down & go with a double McSpicy for twice the goodness but arguably, probably twice the number of toilet runs?
Risk Appetite versus Risk Tolerance
Broadly speaking, depending on the benefits, the level of risk exposure tolerated by individuals may vary. Obviously, the higher the return, the higher the risk exposure.
I’m sure most of you are all too familiar with this graph by now:
Logically, it may be commonsensical to relate a higher appetite for risk with a risk-seeking investor and a lower appetite for risk with a risk-averse investor. However, this form of generalisation runs the risk of over-simplifying risks as a whole (see what I did there).
Therefore, it remains prudent for beginner investors to note the correlation between appetite for risk and tolerance for risk. Irregardless of how risk tolerance is measured, be it quantitatively or qualitatively, it provides a metric with which we can determine the appropriate actions needed to reduce risks to a specified level of tolerance.
In fact, you could perhaps relate it back to the basics of utility optimisation. Again, here’s a handy illustration for you:
As it turns out, appetites for risks are optimised at a certain level as well. As expected returns converge to a stable value, our utilities (or happiness for simplicity) also approximates towards its fair value or diminished marginal return. Or simply, an investor’s utility is optimised when expected returns are also optimised at each level of risk.
Readers familiar with economic theories of diminishing marginal returns would no doubt be shaking their heads at the over-simplification of such a complex model. Again, we’re here for the fundamentals – let’s not scare our beginners away.
Risks versus Returns versus Losses
“Maximise returns & minimise losses”.
If only the world were that simple. Unfortunately or fortunately (depending on your point of view), our investment decisions are more often than not influenced by our emotional bias-ness. In fact, one of the primary emotional biases affecting new investors can be attributed to loss aversion.
Holding all else equal (or ceteris paribus for you finance nuts), loss aversion dictates losses to be on average significantly greater than potential gains. While somewhat true, it should be noted this theory also depends on the composition of an individual’s gamble.
For example, what are my odds of a certain toilet situation while satisfying my McSpicy craving? 50-50? 40-60? 30-70?
In fact, if recent market volatilities are of any indication, risk tolerance plays a crucial supporting role in investing. This is especially so where panic selling or bulk buying in adverse market conditions maybe detrimental in the long run.
A Safe Bet
So, now that we’ve gone through some of the basics of risks and its supplementary forms, are you ready to make your first steps into the foray?
If so, then good on you! Better to have started than to have not started at all. Of course, you’d be naive to think that there are investments out there that are 100% risk-free, as some sources would proclaim.
Investments are at the end of the day, fundamentally still a bet. Whether it becomes a controlled or reckless bet, the onus is still on you as an investor to exercise restraint (when applicable).
With that said, here’s a helpful investment guide:
If you’d like to know more, I found this article from Nasdaq to be incredibly helpful in relating the topics of risk, losses and returns to long-term sustainability in investing.
I’ll see you in the next one!