Why you might be taking on more investment risk than you should
Mitchell Barr, Client Associate
Friday afternoon happy hour is one of the great traditions of working in business. The sleeves get rolled up and another week gone by is celebrated with a few cocktails to kick off the weekend. I’m no exception when it comes to enjoying a drink after a hard week of work. A cold craft beer is usually my drink of choice. That first frosty sip of a malty porter hits my lips like the kiss of an angel and suddenly everything in the world is right. The rest of the first beer goes down pretty well, too. In fact it goes down so well I usually order a second one. At this point I’m feeling the alcohol warmly running through my veins, but my stomach is starting to get a little full. It takes me longer to finish the second beer, and if I go for a third one, well, it definitely doesn’t taste like the kiss of an angel anymore. This describes the law of diminishing returns.
The diminishing returns I experience when I’m partying it up during happy hour also appear in investing. In your brain, the first $1,000 gain feels like the first beer at happy hour, but the next $1,000 just isn’t quite as satisfying. It’s no secret that we all want to make money on our investments. The question is, how much risk are you willing to take to do so? Financial markets are pretty efficient in that for every reward there is a risk, and usually the magnitude of each increases in tandem. A venture capital deal that invests in biotech startups is riskier than parking some money in a stock index fund, but obviously the upside could be ginormous.
Yet, the way we experience the relationship between gains and losses is not symmetric. My third porter usually makes my stomach feel like a balloon ready to burst (okay maybe fifth) and completely trumps any pleasure I experienced while drinking it. Likewise, investing losses actually tend to hurt a lot more than gains feel good. This creates a problem when we try to decide whether to hop into the private equity deal or the index fund. By choosing the riskier investment, you are conceding to the potential for more pain than an equivalent gain would give you pleasure. Financially it may be a winner, but mentally you lose either way. Yet, the money monkey in my head still drives me to drink the third beer and likewise it can drive you to investing mistakes.
Greed should never be the primary driver of an investment decision for this reason. A 20 percent downturn in the stock market is not uncommon and biotech startups can vanish overnight. At the very least, a savvy investor should take advantage of the many different risk tolerance questionnaires available online for free. Answering a few questions about risk will at least slow down your thought process and force you to be honest with yourself about how you will react to a large loss. Everyone has their limits, and knowing them can prevent you from having one too many beers
Mitch writes the popular blog, The Money Monkey, where he focuses on common mental mistakes made by investors, how to avoid being your own worst financial enemy, and thinking about investing in new ways.