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Home > Investopoly > There's no need to take a lot of investment risks
Podcast: Investopoly
Episode:

There's no need to take a lot of investment risks
Category: Business
Duration: 00:12:56
Publish Date: 2022-08-23 21:00:00
Description:

I believe that most people have a very similar tolerance for investment risk.  Most people are comfortable achieving a long-term annual return of 7% to 10% if the risk of losing money is very low. In short, I think most people have a low appetite for risk – they prefer to take as little risk as possible and invest in a “sure thing” if the return will be enough for them to meet their goals. 

What is a risk profile

Risk is the probability of not achieving your targeted investment returns. This might happen in two ways. 

Firstly, the investment might end up being a dud with little prospects of ever delivering the returns you desire i.e., an investment mistake. 

Secondly, you might not achieve your returns temporarily, due to intermittent volatility. For example, if you invested in the Australian share market in May 2021, your return just over one year later is zero, as over that time, the market risen, fallen, and subsequently recovered back to May 2021 levels (ignoring dividend income). But this volatility is almost certainly temporary. We know that over multiyear periods (e.g., a decade or longer), the market has always trended higher. 

Most people are only concerned by the first risk because they know volatility is normal and are happy to endure it if they will be rewarded adequately in the long run. 

That said, some people, albeit a minority, have a low tolerance for intermittent volatility. 

How do you measure your risk profile 

The traditional way to measure risk tolerance is by asking a series of hypothetical questions to measure your comfort/discomfort with experiencing volatility and investment losses. This questionnaire is a good example, which we use in our practice (it’s based on this paper). 

However, I am skeptical that these questionnaires provide reliable information. It’s one thing to predict how you’d feel if your investments fell by 30% of value, but until your experience it, you don’t know for sure. We know that humans have a strong cognitive bias for loss aversion – the pain of losing is psychologically twice as powerful as the pleasure of gaining. 

95% of people have the same profile 

I describe most people’s risk tolerance below (including my own): 

I work hard for my money, so I don’t want to take high risks and risk losing it. I’d be happy to generate a long-term investment return of 7-10% p.a. as I know that if I do that, it will help me build substantial wealth over many decades. But I want to take as little risk as possible to achieve that. 

Warren Buffett famously has two rules for investing. In essence, he counsels investors to not take huge risks. Don’t gamble with your money. Only invest if you are convinced that there’s plenty of upside and very little (no) downside risks.   

5% of people have very different risk appetites 

There are always outliers. Some people will have a very low tolerance for risk and therefore should skew their investments towards safer, low-volatility asset classes. 

Conversely, some investors have a very high-risk tolerance and enjoy “betting the farm” in the pursuit of high returns. 

But both cohorts constitute a very small minority, arguably even less than 5% of all investors. 

At some point, capital preservation becomes more important than capital returns 

Investors know that they must be prepared to take some risk to generate inves
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