A person’s risk-taking depends on factors such as familiarity and emotions. For someone who haven’t invested before, the familiarity factor is a large influence in their risk-taking.
Your everyday life is filled with risk and that’s how life works. Statistics show that each year,43,000 or more of the United States’ population die due to vehicular accidents and around 2.9 million people end up suffering light or severe injuries. However, people still get in their cars every day as it’s a convenient form of travel.
Have you ever had that feeling that you want to advance in your career by taking another job but you can’t take the risk to lose your current job? This is familiarity that plays in to your risk estimation. In an interview with the Wall Street Journal, Margie Warrell said;
“Most people overestimate the probability of something going wrong when they venture into unfamiliar turf… They also overestimate the consequences of things going badly.”
Warrell is the author of “Stop Playing Safe.” and a Melbourne, Australia-based authority on risk-taking, who has coached many U.S. executives and employers. She further concludes that;
“With experience, they become more realistic, and learn they can handle the consequences of failure. The more often we step out of our comfort zone, the more we build our tolerance for risk-taking,”
Too Scared to Participate?
In modern portfolio theory, risk aversion is measured as the additional marginal reward an investor requires to accept additional risk. Risk is being measured as standard deviation of the return on investment. In theory, this is all well and works seamlessly but in practice we behave differently. If you’re looking to invest as a beginner you often overestimate the potential losses that you could incur, due to the unfamiliarity factor. In most cases this overestimation is so big that you don’t invest at all, leading to the inflation gnome eating up all your money instead.
If you look at S&P 500 over the last 10 years it had an annualized return (this is how many % your investment grows each year) of 8.6% and you’ll also see the standard deviation, or risk, during that time period was 14.7%.That means, in any given year, the S&P 500 index could be 14.7% higher than 8.6% or 14.7% lower. This is the risk of the broad stock market. As a beginner, one might overestimate the risk of this investment and stay out of the market instead of cashing in on the 130% return that this 10 year investment would have yielded. In layman’s terms, if you had $10,000 to invest 2003 and you knew that in any given year you could potentially lose $610 – $1,403 or you could make $2,330 – $5,359, would you invest?.
The end result of this investment would have been a gain of $13,000, compared to $0 if you stashed your money under the mattress. Even if you would have placed it at a 2% savings account you would only get $2,190 after 10 years. (FYI this investment didn’t fall below $10,000 any the 10 years, even after 2008 you were still up $591) This seems like a no brainer, but the unfamiliarity factor of investing is refraining many of us to actually invest.
How to Change Your Risk-Taking Behavior
The environment can actually change your risk-taking behavior. Sue Shellenbarger, who inspired this blog post, gave a good example in “What Makes a Risk-Taker” on how the environment can shape your risk-taking.
Jennifer Bellinghausen of Austin, Texas, a full-time caregiver to her disabled mother, isn’t a risk-taker and never thought of getting a tattoo. The 39-year-old mother of two is terrified of needles and devotes her time to her family. But when she ventured into Mom’s Tattoos in Austin several years ago with a friend who was getting one, the atmosphere in the shop changed her mind. Owner Deborah Obregon was so friendly that “it was like we were instant best friends,” Ms. Bellinghausen says. Ms. Obregon and another tattoo artist chatted with her for more than an hour, and Ms. Bellinghausen eventually took the plunge and got a 3-inch ankle tattoo of “a little kitty cat,” she says. “It surprised me; I’m not a risk-taker,” she says.
Do you remember the first time getting behind the wheels of a car? Was the 2.9 million annual injuries the major thought on your mind? Probably not, it was probably more about how cool your car was. The comfort of driving to your local grocery store was probably a large enough reward for you to take the risky car ride. This is due to familiarity, where you have seen your parents, siblings, and friends drive before. You might even have taken some lessons to improve your skills before you hit the road by yourself. As one gets more familiar with a risky element the risk-reward preference adjusts rapidly. This is no different from investing, once you’re able to grasp how it works it’s much easier to understand how to get a decent return and understand the risk you’re taking. At SprinkleBit we want to give you that familiarity by giving you our stock market simulator to try out the markets, risk-free. We give you our SprinkleBit University to study how things work, and through our community you can see what your, parents, siblings, and friends are doing. Hopefully, you can achieve your financial goals and hit the road towards your financial freedom.