How To Avoid Risk Aversion In Your Life And Investments

by Hank Coleman

You need to avoid risk aversion.If you had the choice of keeping your current job at your current salary or taking a chance on a new venture that has a 50% chance to either double your income or 50% chance of reducing your income by 25% which would you choose? Let me frame it a slightly different way. Let’s say that you currently make $50,000 at your day job. You could keep working 9-5 and do nothing. Or, you could take a chance with a new venture that has the possibility to either double your income to $100,000 or reduce your income to $37,500. Which would you choose? If you said that you would just stay where you are with your current job and not risk it, you are not alone.

What Is Risk Aversion?

Risk aversion is a phenomenon where a person or an investor is reluctant to accept a loss when there is the possibility to receive a loss. It comes down to what a person perceives as the gain and also the loss. Studies have shown that most people cannot stomach losses. They would rather give up the possibility of a gain in order to ensure that they do not suffer a possible loss even if the risk of a loss is less than the chance of the gain.

Understanding Expected Value

So, how do you avoid risk aversion? The best way to avoid risk aversion is to understand expected value. In statistics and probably theory, expected value is the weighted values of all possible outcomes. So, for example, if a stock valued at $100 per share has a 50% chance of rising to $150 during the course of a year and a 50% chance of dropping in value to $80, then it has an expected value of $115 ($150 x 50% + $80 x 50%) by the end of the year.

Putting It All Together

So how do we put it all together and what does it all mean to the average person. The one surefire way to have half a chance to avoid risk aversion is to understand it. It is everyone’s natural inclination to want to avoid losses. No investor wants to lose money, but it is important to understand that many of our fears are not founded in science and actuality. Often the fear of suffering a loss, even a small loss, keeps us from potentially earning significantly more money with other opportunities.

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Have you ever thought about starting your own business but were scared about the potential downside? Did you ever balk at a new investment idea or stock that you had a great feeling about? Loss aversion can keep us from earning more in our lives. It is through understanding the human psyche and yourself that can help you avoid risk aversion in your life and investments.

What about you? Has there ever been an investment that you balked on out of fear of a loss?

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About Hank Coleman

Hank Coleman is the founder of Money Q&A, an Iraq combat veteran, a Dr. Pepper addict, and a self-proclaimed investing junkie. He has written extensively for many nationally known financial websites and publications. Hank holds a Master’s Degree in Finance and a graduate certificate in personal financial planning. Email him directly at Hank[at]MoneyQandA.com.


Hank Coleman has written 574 articles on Money Q&A. Learn more about Money Q&A on Twitter @MoneyQandA and @HankColeman.


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{ 4 comments… read them below or add one }

Eric J. Nisall - DollarVersity

Some people are just inherently nervous and risk averse, with no way to quell those feelings no matter how much they understand or temper their expectations on returns (or whatever else the risk may be).

I know one particular family that watch the markets so closely that the father and daughter can have as many as 5 calls back and forth any time something happens in either direction. It can be “oh, holding x is up 3%, should I sell it now while it’s profitable” or “this holding is already down 1%, you need to sell it for me before it loses any more, I can’t afford to lose any more than I have already”. It really is annoying just to hear the complaints and worries constantly. I sometimes want to tell people to go hide out in a cave so they don’t have to worry about anything since everything seems to set off their nerves.

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Miss T @ Prairie Eco-Thrifter

For me it would really depend on the job. If I could do something that has always been my passion and that I know I would love, then the pay cut wouldn’t matter to me. We would make it work because doing what you love is a great thing.

I tend to be a risk taker whereas my hubby is more conservative. We balance each other out quite well.

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Marie at Family Money Values

It is true that some people are just more naturally risk averse than others.

It helps, as you say, to analyze the risk and the potential outcomes, to learn as much as you can about how to mitigate the risk and have a plan in place to deal with a situation that does materialize.

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freebird

When I was younger I had some investment ideas and I would get livid when they seemed to inevitably shoot higher as I was “mulling it over”. For some reason those near-misses bothered me a lot more than buying shares that later tanked. So now I hesitate less, but I do keep a large fraction of cash to be able to play new ideas so my overall risk isn’t that much. Plus if you diversify your bets, you’re much less likely to wipe out. I personally don’t borrow to trade, to me that’s going too far.

These days financial professionals seem to be getting a lot of bad press, but I think this is where they have added value to society– namely by helping the masses overcome their natural risk aversion. It’s how my generation has accumulated wealth even on modest wages, by regularly putting money into risky investments through thick and thin. Unfortunately the whipsawing over the past decade has turned the younger generation into a risk-off cohort, so it’ll take some convincing to get these kids to do the right thing for the long term. This I believe is your mission.

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