COLUMN: Risk vs. reward
Will an increase in your net worth have a big impact on your life?
I was reading a very interesting article about how risk perception has changed dramatically over the past five years. This could not be more true.
When I think back to the mid and late 1990s, just about every client that walked into my office stated growth as their number one objective.
Equities ruled. Fixed income, safety and capital preservation were usually stated as an afterthought by most clients. How the landscape has changed.
The number one objective I hear today is, "don’t lose me money."
The focus has certainly shifted towards capital preservation. This is now true with every age group I deal with, from the young couples starting out, to the retirees.
Are you willing to take risks to improve your financial picture, or is it minimizing the risk of losing the money you have which is critical to your lifestyle?
Personally, I have always believed in “asymmetric loss aversion,” a fancy term that simply means losing hurts more than the good feelings you experience when winning.
For example, if you had a $100,000 in your investment account, it would be nice if you could grow your account by $50,000.
But the idea of losing $50,000 of your money is much more painful than the pleasure you might feel from increasing your account.
I was taught very early on in my career that risk has to be experienced before you can be honest about how much of it you are willing to take on. Quite a paradox, isn’t it?
When it comes to risk perception, certainly some people have a much greater appetite for it than others. It has a lot to do with your age, goals and your personality. It's more than just money, what your net worth means to you is really important, but it is interesting most of the investors I work with have a completely different outlook on risk today.
Each dollar we earn over the threshold necessary for survival has less significance to us than the previous one. Because the first dollar satisfied our needs to some degree, and future dollars are used to satisfy less and less important desires. Economists call this “the law of diminishing returns.”
Since each additional dollar is worth less and less to us, we are more concerned with losing a dollar than gaining one. If we lose money that was intended to satisfy greater desires, we feel worse than if we don’t gain money that would be used to satisfy lesser ones.
This concept becomes even more important when it comes to income. If you live a comfortable lifestyle, have a nice home, take vacations, and you don’t worry about prices at the store, a big raise may not significantly add value to your life.
But if you reduce your income by half, you will definitely feel it.
Think about this as you clarify what money can and cannot do for you. Will additional money add very much to your lifestyle? Or can you add more enjoyment to your life by better managing what you have?
Don’t take unnecessary risks with your money. The anticipation of great reward will not outweigh the pain of a substantial loss. What suits your needs best is up to you. Speak with an investment professional to ensure you are truly in your comfort zone.