Archimedes Finance

Become a better investor


Consider risk

Lesson in Course: Investing basics (beginner, 7min )

The future is filled with uncertainty. How should we think about risk when investing?

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.

Loss aversion

Two brilliant psychologists, Daniel Kahneman and Amos Tversky studied how people make decisions, leading to the principle of loss aversion. They found that we prefer to avoid loss over gaining the same amount. 

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, like selling a stock just because the price fell one day, and we're afraid 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.

Gain then loss example

Year 1: $100+ 50% x $100 = $150

Year 2: $150 - 50% x $150 = $75

We did not break even. We are down $25 compared to where we started despite going up and down the same percentage.

 

Unfortunately, the math shakes out the same way even if our investments fall and then rise by the same percentage.

Loss then gain example

Year 1: $100 - 50% x $100 = $50

Year 2: $50 + 50% x $50 = $75

We can see that the outcome of down 50% followed by up 50% results in the same outcome as the previous example.

 

Risk tolerance

The amount of risk we are willing to take defines our risk tolerance. That willingness comes down to managing our emotions, especially when responding to loss aversion. If our investments cause us to lose sleep and give us anxiety, perhaps we've taken on too much risk. We need to make sure we can keep making rational investment decisions.

Risk aversion is a tendency to prefer investments with lower uncertainty (lower risk) to investments with high uncertainty (high risk), even if the possible gains on the high-risk investment were significantly higher. 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.

The amount of money and time needed also plays 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.

The video below provides more depth on how we might think about risk and investment uncertainty:

We can mitigate the short-term risks from daily changes in prices by being long-term investors. On any given day, the stock market's value might go down, but if we wait long enough, it will continue to rise over the long term.

We can also lower the chances of losing money by diversifying our investments.

Lastly, if we are unsure about investing and don't think we can manage the emotional aspect, we can always get professional help. Robo-advisors do all of the investing for us so that we 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 us out for a more personal touch.

Glossary

What is Loss aversion?

Our preference to avoid loss over gaining the same amount. The pain of losing $300 is more powerful than the pleasure of winning $300.

What is Risk Tolerance?

How much risk we are willing to take.

What is Risk Aversion?

A tendency to prefer investments with lower uncertainty (lower risk) to investments with high uncertainty (high risk), even if the possible gains on the high-risk investment were significantly higher

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