Nearly everything is a question of risk. And, if this is the case, it surely pays to know how we make our own calculations. What drives our decision-making process? How can we gain ground on the Socrates maxim, “Know Thyself”?
Before going further, “at risk” of this post carrying a very investment specific tone, my hope is that we might see applicability far beyond a stock market. Everything involves risk.
Something feels physically “off”. Should I take time to go to the doctor or should I risk a few days and see if it will pass?
I might not like the taste of this food. Should I risk not liking the taste or should I be open to something new?
We could travel the world and learn about other cultures. Should we risk the time and money or should we stay home and read about it?
Should I travel to see my loved ones during a pandemic? A question of risk.
The jobs we choose. Where we live. What we spend our money on. How/if we invest. All questions of risk. Everything is a cost / benefit analysis, judging whether the upside is worth the potential downside.
Even driving to the grocery store. Driving is one of the most dangerous activities in which we engage, but the risk of going hungry exceeds the risk of getting injured in a car accident. So, we accept the risk. (Or, we order, but you get the point.)
Not one moment goes by that we aren’t at least making some sort of subconscious calculation of whether this is worth that.
The field of behavioral finance has made significant strides in the last decade. Here’s a quick glimpse with an overly broad brush as it pertains to risk. We’ll frequently find our personal risk calculations categorized by 4 main categories:
- Prospect Theory
- This is where individual biases of what we consider “wealth” are accounted for – we all have different reference points. Wealth to me is different than wealth to you. In other words, gains / losses prove to be more important than final outcome. Changes to current status are perceived higher value than how we might end up. Furthermore, almost universally, the pain from loss is greater than the pleasure of gain.
- The Big 5 Personality Traits
- Not without its controversy, these traits seem to be the most broadly accepted for personalities to be compared/contrasted. Somewhere, you’ve likely seen these 5 dimensions: openness to experience, conscientiousness, extroversion, agreeableness, and neuroticism. Maybe without much surprise, risk propensity is most correlated to high scores of extroversion and openness to experience and low scores of neuroticism, agreeableness, and conscientiousness. More on this – stay with me.
- Cognitive Capacity
- Here, a measurement of our ability to substitute an impulsive and incorrect response with reflection. This also accounts for the likelihood to embrace risk if we understand clearly what we are participating in. Confusion kills trust – if we don’t comprehend an investment, political ideology, religion, or even a type of food – then, we’re less likely to engage.
- Investor Profile Analysis
- Think about the tool used when enrolling in a 401k at work or opening a brokerage account. We’re asked about our investment experience, time horizon, what you would do in the case of a market crash, etc. In much of personal finance, we’ve, unremarkably, not gone much further than this mechanism in creating risk profiles.
Where do we go from here?
Like most gray areas, defining a precise process is difficult. Risk is fluid. True, there are some hard-wired predispositions that are difficult to circumnavigate. But, our willingness to take on risk is a checks and balances between our current / previous status, personality characteristics (some genetic, some not), and our ability and eagerness to understand something. Chase that down with a spouse’s differing risk appetite and that’s quite a cocktail.
My suggestion is a constant revisiting of risk. To be clear, this plays out in so many more areas than a stock market investment. We’ll notice degrees of risk propensity with how quickly we move on big decisions, how we raise kids, career moves, where we choose to live, when and how to retire, and yes, how we build wealth. There’s plenty at stake in our self-critique.
And, if this is the case, surely we can acknowledge that leaning on a bank or brokerage firm’s generic risk tolerance questionnaire doesn’t suffice. We need to know more.
There’s likely reason to draw real connection between how we live our daily lives and how we accept risk. This way, in the face of adversity or confusion, the reaction is to reflect, not react. Maybe our default is appropriate, maybe it’s not.
Meaning, if we’re highly neurotic about how straight the lines are when we mow our lawn or how tidy the house is kept, then we might have a lower risk tolerance than we think.
If we’re adventurous eaters or love to travel (openness to experience), maybe we’re greater risk takers than we realize.
If we diligently price hawk every purchase (conscientiousness), this likely contributes to desiring less risk.
And we’ll find in this exercise, that our traits and experiences become very conflicting. While something might suggest we’re very risk averse, another might suggest strongly otherwise. Maintaining harmony with our genes, environment, and life experience is constant work.
For instance, I always score very high in ‘openness to experience’, which implies a high tolerance for risk. However, referencing the ‘Prospect Theory’ from above, my quality of life has improved over the last decade. This actually makes me more risk averse.
For me, the thought of loss resonates far more than the potential pleasure of gain. I drive slower. I eat healthier. I exercise more. Professional decisions give more weight to the downside than before. The thought of not being available to my family is nearly unbearable.
I revisit, though, that risk is fluid. The fastest way towards growth is through suffering. Some sort of chaos, humiliation, or failure. Taking all chips from the table is a lousy option. In what might be perceived as twisted, we want things to occasionally go “wrong” – maybe even very wrong. This creates space.
In order to stay centered, sometimes we need to lean left and sometimes we need to lean right. Our willingness to accept risk will always fluctuate. Sometimes, our comfort zone isn’t the answer. Ironically, years of default responses – or sleepwalking – can actually prove to be quite risky behavior.
We want to live in the paradoxical place of having so much to live for that taking mindless risks is inconceivable – yet we’re still unattached to the outcomes from the activities and roles we’re so greatly invested. Caution and surrender. If you succeed in this, please let me know how. But, this is our North Star.
This constant risk analysis for ourselves will reveal itself in forms of progress followed by harness. Two steps forward, one step back. Success followed by missteps. Investment statement gains, followed by declines. Comfortable then uncomfortable. The back and forth is necessary for everything.
Life is risky business.
Thanks for reading,