I don’t really like roller coasters. It’s not that I’m terrified of them – it’s just that I get absolutely no enjoyment and feel like I’m exposing myself to a bit of danger (they’re maintained by high school kids, you know) and stomach lurching for no reason at all. Plus you have to pay for it, which seems downright ridiculous.
You, on the other hand, may like roller coasters. And that’s OK.
It’s fine for us to have different views on roller coasters, because we’re totally different individuals.
You want to know something else it’s OK to have differences on? Our appetite for risk. (Wait, that could still be roller coasters…let’s clarify). Specifically, our appetite for financial risk.
I don’t see a lot of personal finance discussions about risk. It’s alluded to – like when people suggest that asset allocation may change depending on your time horizon or when people discuss paying off their mortgage – but it’s rarely discussed outright. That’s a shame, because risk is one of the most important things to understand when discussing personal finance.
In fact, some online personas seem to be almost risk-neutral. With chiseled jaws and nerves of steel, they laugh right in the face of risk. They’re happy to be 100% invested in stocks and think folks who pay off mortgages early are fools. Granted, they’ve never actually been through a market downturn, but how can that possibly be relevant?
What’s Your Appetite for Risk?
So today, I’m going to dust off my Decision Science notes and have fun quantifying your appetite for risk. I’ve got a hypothetical wager I’d like you to consider, and you’ll need to tell me the odds you’d need to take it.
Here’s the deal:
If you win, you’re paid $1,000. If you lose, you have to pay $1,000.
What minimum probability of winning (p in the above) do you need to take this wager?
I know everyone would be willing to take the deal if you had a 99% chance of winning $1,000 and a 1% chance of losing $1,000. I need to know the minimum odds you’d need to accept it.
Sidebar for only the Decision Scientists among us: Yes, I know with one reasonable assumption I can use this single wager and the answer (as long as it’s <>50%) and plot everyone’s u-curve and project what they’d do in any deal and be done. But that’d involve a lot of boring math and explanations, and they already think we’re total nerds. So just roll with me.
Most people will require something north of 50% for p to accept this wager. Some brave souls may be OK right at 50%. And if you’re a risk-loving thrill seeker who would accept this wager with less than a 50% chance of winning, please contact me immediately as I have a deal for you.
As soon as p goes above 50%, this is, mathematically, a good deal. But that will be small solace if you happen to be on the losing end. The fear of that loss is what requires most of us to have significantly more favorable odds of winning.
Now let’s do the same offer, but increase the payouts: + $10,000 and – $10,000. If you’re troubled that you want a higher p to play for these increased stakes, don’t be. It’s a reassuring sign you’re human.
And for a final data point, let’s look at +$100,000 and – $100,000. Fear and greed are in full-fledged battle! Being handed a cool $100K would be great, but it’d be a painful check to write if you lose.
What Does p Tell Us?
If you are indeed human, you most likely needed a p greater than 50% to accept the $1,000 wager. You needed an even higher p to accept the $10,000 one and higher still for $100,000.
If you did, it means you’re risk-averse. That is not a bad thing, or a sign of weakness – it’s part of being human. All things equal, why would we favor uncertainty over a sure thing?
The nice thing about this wager is it allows you to compare your risk tolerance to that of other people. If you required a 65% chance of winning $1,000 to take that wager, and someone else only required 55%, that’s a meaningful difference. The two of you could face the same financial decision, make totally different choices, and both be perfectly rational. That’s important to understand.
What If My p Is Really High? Isn’t Being Extremely Risk-Averse Bad?
Well, I guess it’s bad in that it may make it much harder to achieve your financial goals. If you’re terrified of loss, you might avoid the stock market and other risky investments altogether, and those have historically been great ways to increase wealth.
But it’s also just a part of who you are. Telling someone he should accept lots of risk because math and history says he should is like strapping me into a roller coaster and telling me it IS fun so I’d better enjoy it.
The goal today isn’t to shift anyone’s risk tolerance. It’s just to establish that we are indeed risk-averse and then measure where our current risk tolerances lie.
And that’s where you can help. Once you have your minimum probability p to accept the $1,000 wager, please let me know what it is in the comments below. It would be helpful to show that we’re all different and there’s a range of risk tolerances among us. As fascinating as Decision Science is – oh and it is fascinating – the value of this post will be much greater if you can compare your risk tolerance with that of other readers.
I’m planning on discussing risk in future posts – especially how it influences some major investment decisions (e.g., mortgage payoff). I do want to challenge that there is ever a single “correct” choice for financial decisions involving risk. We’re all different, and our decisions should reflect that.
What odds do you need for the $1,000 wager? The $10,000 one? $100,000? Do you like roller coasters? Please me know in the comments.
If you’re a first-time commenter, it’s easy and you can be anonymous – we just want to see your p 🙂
Picture courtesy of Stefan Schweihofer