Investor Risk vs. Reward

Ashley Revell is perhaps the archetypical risk taker. In 2004, he sold all of his possessions, save for one set of clothes, and placed a double or nothing …

Ashley Revell is perhaps the archetypical risk taker. In 2004, he sold all of his possessions, save for one set of clothes, and placed a double or nothing bet of $135,300—all of his money—on one spin of the roulette wheel. Revell chose red and came away with $270,600.

Such risk does not appeal to everyone.

But even the most conservative investors must deal with risk when planning for their futures. “Essentially, gambling is taking a risk for the sake of reward,” Dr. Frank Murtha, managing partner of Market Psychology Consulting, said. “Investing is a form of gambling, it’s just that the odds aren’t against you.”

“When it comes to risk perception, certainly some people have a much greater appetite for it than others,” Murtha said. “It’s going to have a lot to do with what their goals are…as well as their personalities.”

Even genetics play a role. A team of Israeli psychologists have located a gene, D4DR, that is “also known as the thrill seeking gene,” Murtha said. “Indeed, a lot of [risk tolerance] is genetic.”

Those with a mutated form of this gene tend to gravitate toward riskier activities than the average person because they react more strongly to dopamine, a neurotransmitter that influences pleasure and emotion.

In addition, those who experience success early on are more likely to take unnecessary risks later in order to experience that euphoria again. “Early experiences have a lot to do with the way people go about [investing],” Murtha said.

“You can’t rely on early successes; such reliance instills false confidence,” Ari Kiev wrote in his book Trading to Win.

Recent experiences are another key component in determining risk tolerance. “What’s happened most recently is really the predominant factor that affects people’s risk taking,” Dr. Richard Peterson, managing partner of Market Psychology Consulting, said. “People who’ve recently had a big win in their portfolio are more likely to view risk as a benign thing.”

Fear of failure

The fear of losing money often has more influence over people’s investment decisions than their desire to make money. “Because of the pain of loss, people are willing to take greater risks to reduce that pain and to avert it than they are willing to do to maximize their profitability,” Kiev wrote.

People avoid risk because they are afraid of being wrong, of making an error, of failing.

“It’s desire to not lose money that is at the heart of risk behavior,” Murtha said. “People are actually loss averse.”

In the wake of the Great Depression, for example, many people shied away from the stock market, stashing savings in mattresses and avoiding investments that seemed risky. Fear became the primary emotion that drove many people’s investment decisions.

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Even today, many people become scarred by their failures and become obsessed with avoiding risk rather than earning gains. “In fact, many people fail financially not because they take too much risk with their money, but because they take too little risk with their money,” Ric Edelman wrote in his book The Truth About Money.

Investors who focus more on minimizing risks rather than maximizing returns are actually setting themselves up for failure. “People who are afraid of risk…end up earning lower returns in the long term,” Peterson said.

In order to keep up with inflation, every portfolio must contain riskier investments that will provide the necessary returns. “Cash is not risk free, because the value of the money, in terms of buying power, cannot…keep up with inflation,” John W. Schott wrote in his book Mind Over Money. “Instead of thinking ‘safety,’ you need to think ‘spreading out the risk.’”

“Greed, when controlled, is the most valuable emotion an investor can have,” Schott wrote. “We are hungry for profit, so we will take the reasonable risks necessary to get it.”

Emotions

Investors can combat their fear of failure by acknowledging that they will experience highs and lows while investing. “Prepare yourself emotionally…for future ups and downs,” Murtha said. “Allow yourself to recognize that you’re going to have these scary moments.”

The ability to accept errors and failures as they occur is also important. “Many people can’t accept the need to change their minds once the choice has been made and money has been invested,” Jonathan Myers wrote in his book Profit Without Panic. “This type of behavior, where investors mentally justify their strongly held beliefs—even when they conflict—is known as dissonance. If they take positive action to safeguard their money, they have to accept that they were wrong, which is very hard for some people to do.”

Many investors will stick with losing investments for this reason; they don’t want to admit failure. Having already lost money, they are afraid to lose pride, too. Thus, rather than cutting their losses and moving on to other investments, people will often stubbornly hold onto their unsuccessful investments. “When you get right down to it,” Murtha said, “people hate admitting they make mistakes.”

Good investors know better than to allow themselves to fall into the trap of such thinking. Successful investors, Schott wrote, do not agonize over mistakes; rather, “they treat mistakes as a learning experience.”

“You can change your perception of an experience so that negative feelings don’t get anchored to a particular bad event…by attaching positive feelings to negative events and learning the value of those experiences,” Kiev wrote.

What separates successful investors from unsuccessful investors, Steve Cohen wrote in his foreword to Kiev’s book, is that good investors “have the ability to admit their mistakes and minimize their consequences—that is, losses—when they are wrong.”

Successful investors are also careful to try to remain objective, and to keep their emotions from influencing their investment decisions. “The inherent risk of an investment at any given time is stable or assessable, while perception of risk can fluctuate according to whim, bias, and external influence,” Myers wrote.

People who let their emotions cloud their choices will often make poor choices. “Neither despair nor euphoria should cloud one’s judgment,” Kiev wrote.

People who are able to separate their emotions from the investment process are more likely to be successful, Murtha said. Those who let the fear of past failures overshadow the lessons they could have learned, and those who are willing to gamble everything to experience the euphoria of a winning investment, will not make solid decisions based on numbers.

None of this means that investors should strive to be emotionless. “The fact is, we’re humans, we’re not Vulcans. Experiencing emotions is natural,” Murtha said. “The key is you can’t let those emotions…grab the wheel and drive your investing decisions.”

Risk management

No investment will ever be risk-free. The sooner investors focus on earning rewards rather than letting their fear of risks paralyze them, the sooner they will become successful. “Life involves functioning with uncertainty, but we usually don’t embrace it,” Kiev wrote. Risk is something to be acknowledged, not avoided; it is impossible to totally avoid risk.

“The ideal situation, for an extremely risk-averse person, is to work with someone to construct a balanced portfolio,” Schott wrote.

Murtha recommended that investors enlist a financial professional to help them learn to maximize their investments in a way that correlates with how comfortable they are with risk. “Tiger Woods has a swing coach,” he said. “That tells me that the people who are really, really great at something aren’t afraid to get help.”

However, a balance must be struck between getting help and relying on others too heavily. “Having one’s hand held too much can make a person more risk averse, because risk aversion is strongly linked to lack of confidence, and you can’t increase confidence by relying heavily on others,” Schott wrote.

“A financial stress management plan…is great to have in place so that when bad times hit, you’re ready for them,” Murtha said.

“Develop patience and don’t panic when you lose money,” Kiev wrote. A panicking investor is not an investor who will make rational, smart decisions. Markets and economies rise and fall; the key is to keep a level head when things take a downturn.

The best investors “possess risk taking ability, flexibility, and a capacity for conviction,” Kiev wrote. “They have the ability to stay in the present and view events truthfully and, therefore, objectively.”

A person who is calm, cool and collected will be able to make better decisions than someone who is scared and stressed. To that end, “find good, healthy things…to replace potentially unhealthy things,” Murtha said. “I’m talking about something as simple as writing down on a piece of paper the top 10 reasons why you got into these investments and should stay there…it could be something as simple as taking a nice, long jog.”

Conclusion

“Some people do take too much risk, but as long as they are resilient and realistic and learn from their mistakes, they often make the best investors in the long term,” Peterson said.

In the long run, not taking enough risks could be just as dangerous, if not more dangerous, than taking too many risks. Successful investing is “a question of finding a comfortable balance between risk and security,” Myers wrote.

It is also important for investors to take an active role in their investment decisions, even if they are working with a financial professional. “Having a sense of control lies at the heart of being able to mitigate our fears,” Murtha said.

“We need to put ourselves in a place where we can make the decisions that are hard but necessary for our futures,” he said. “The best way to do that is to have a long-term focus on goals.”

“In a short-term framework, taking an action, taking a risk, and having it turn out poorly is much more painful than is doing nothing,” Murtha said. However, “In the long term, people tend not to regret the things they did nearly as much as the things they failed to do.”

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