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?