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Investing is Risky Business
From the editors at WIFE |
These are the times that test
investor’s souls, or at least their tolerance for risk. If you invest in technology,
biotech and other stocks that trade on NASDAQ, you’ve seen quite a bit of volatility
this year.
What does the future hold? More volatility, which means risk. In stock market
terminology, risk is the chance that your investments will go up or down. The wider the
swing, the greater the risk. That definition of risk deviates from investor psychology in
one enormous detail. Most of us don’t consider it a big risk that our portfolio will
increase in value more than expected. We consider that a blessing. We define risk only as
the risk that our portfolios will go down, not up. Yet volatility swings both ways, and to
get the greater returns on the upside, we have to tolerate the gut-wrenching dips on the
downside.
Too much risk causes panic. If you take on more risk than you can stomach, you are
likely to bail at the worst time, when your portfolio is way down and you have lost your
courage. You’ll lock in losses in stocks and bonds and mutual funds that probably
would have recovered, had you only given them time. So one of the most important things an
investor can do is to figure out how much risk you can tolerate, and don’t indulge in
investments that are riskier than you can tolerate.
In volatile times you overestimate risk. Your tolerance for risk shifts somewhat based
on your recent experiences. Last month I flew cross-country not long after a spate of
airplane crashes. Though I’m usually a confident traveler, on the first leg of the
flight I was agitated at every bump and air pocket we hit. But on the return flight, I had
acclimated once again to the ordinary ups and down of the air currents. That’s human
nature – through our biology, we are intended to overestimate risk. When we encounter
a frightening event, our bodies react, and when we encounter the event again, we are wary.
That kept our ancestors out of the path of saber-toothed tigers. But because we are
programmed to avoid pain, we have a distorted view of investment risks. Our instinct is to
get out of harm’s way rather than to take a more appropriate long-term perspective.
It’s painful to lose. Most people feel the pain of losing much more than they
experience the pleasure of winning. If you have the chance to participate in a coin toss
where you’ll win $20 if it’s heads, and lose $10 if it’s tails, most people
would take the bet. You’ve got a 50% chance to win, and the potential loss is minor.
Experimenters have found that if they raise the stakes, most people shy away. Heads you
win $20,000, and tails you lose $10,000 is perceived as much more risky, even though the
odds are exactly the same.
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