Consider this scenario: two investment options on the table. Option A offers a potential 63% gain but also carries a 77% risk of loss, while option B guarantees a 4.5% return. Many opt for A. Yet, when faced with the harsh reality of losing your investment, regrets may surface. Does this ring a bell? Turns out, Option A refers to Nvidia stock and Option B is the current yield on the 10-year Aussie government bond.
When evaluating an investment opportunity, the primary concern revolves around the level of associated risk. Most people have an emotional rather than an objective understanding of risk. They often equate high risk with high reward, neglecting the fact that high risk also comes with a higher probability of severe losses.
Now, an economist would tell you this regret you experienced is called loss aversion bias. It occurs when you feel more pain from losing money than pleasure from gaining money. However, have you ever questioned yourself: why did you choose A at the first place if you weren’t willing to accept the risk of losing?
Loss aversion complicates people’s emotional understanding of risk. Thus, having a more informed and objective understanding of risk serves as a crucial first line of defence against making suboptimal investment decisions.
This holds particular relevance in today’s markets, where new themes and instruments (NFT, SPAC, Cryptocurrency, 0DTE, ARKK, TSLA) constantly vie for investors’ attention. Just like riding a wave, risk adds thrill to life. But get it wrong with your investments, it can wipe out your financial wellbeing.
When assessing investments, a rational investor should ask the following questions:
- What is my risk tolerance level? i.e., how much am I able to lose without jeopardising my lifestyle.
- What is my risk appetite? i.e., once I know the risk I can afford, how much risk am I willing to accept?
Having a high tolerance and appetite usually indicates lower levels of risk aversion, while a low tolerance and appetite suggest higher risk aversion. As a result, your risk aversion level should guide the choice of investment products that suit your circumstances.
Having gained an objective understanding of risk, you might concur those investments like Bitcoin, known for their volatility, aren’t suitable for everyone. Conversely, a risk-seeking investor shouldn’t lament substantial losses. Embracing risk means acknowledging the potential for losses and accepting them as part of the investment.
Yet, embracing investment losses doesn’t mean neglecting due diligence. This leads to the second mistake commonly made by investors.