The recent hype around Gamestop, cryptocurrency and non-fungible (NFT) tokens made me wonder if anyone is still risk-averse.
Do you prefer a consistent return to a 50/50 chance of winning big or losing it all?
Yes, I am sure that the answer to your question is “yes.”
Over $4 trillion is invested in passive funds, meaning that many people are using a long-term strategy.
It still feels like everyone is playing with their hard-earned money like they’re in Vegas for the first time. It’s only partially true.
Dogecoin, the crypto that began as a joke… oh, yes, it was a joke) has a value of almost $50 billion.
Ford’s market capitalization is less than $50 billion.
It was a good idea to revisit the reasons why I had passed on such investments. They are risky.
Table of Contents
The Definition of Risk
Risk-Averse Definition
Five Questions to Ask Yourself To Determine How Risk Averse you Are
What Your Results Mean
Personal Finance: Risk Aversion and its importance
The Definition of Risk
Merriam-Webster defines risk as “the possibility of injury or loss.”
When dealing with personal finance in this instance, we’ll focus on the three first words: the possibility of losing money. Particularly, financial loss.
High-risk investments are likely to lose value and result in you losing your money. Investments that are high-risk include equity, NFTs and cryptocurrency.
A low-risk investment is one that has a very low chance of losing value. Bonds and certificates of deposits (CDs) are low-risk investments.
The middle is where you will find everything, including real estate.
Although risk is not a measure that is binary… time is another variable to be considered when determining the risk.
Generally, the longer you own an asset, it becomes less risky. In any given year, for example, the S&P 500 can go up or down 30%. This is a risky option.
Over time, the risk becomes less. Over the course of most 20-year periods, you can expect an average return on S&P 500 of +5-10%.
When you’re 20 or 30, and are just starting to invest, it makes sense for you to start with equity. You will be investing over a long period of time.
It makes sense, when you are close to retiring and will need to access your money within the next few months or years, to shift your portfolio to conservative investments. Because your time horizon is shorter, investments, in general, get riskier.
Risk-Averse Definition
Avoiding risk is the definition of risk aversion. It’s pretty straightforward.
You will choose investments that have a low chance of losing value if you are a cautious investor. You value the preservation of your money over maximizing returns.
The trade-off for being a risk averse investor, is that your returns will be lower. You will instead receive smaller, but consistently positive returns.
Someone who is risk-averse will prioritize finding the highest possible return, over safe investments.
Five Questions to Ask Yourself To Determine How Risk Averse you Are
I created a 5-question quiz to determine your risk aversion level.
Some of these questions are subjective, while others have objective answers. All of these questions will help you determine what level of risk you are comfortable with, which you need to know before you start building your investment portfolio.
Question 1: When Are you planning to retire?
0-5 Years Away
Six to ten years is a reasonable timeframe
Ten to twenty years away
20+ years from now
Question 2: What is the size of your emergency fund?
I don’t have one
Save 1 Month
Save up to 2-3 months
Save up to 3 Months
What would you choose for your investment returns this year?
A Guaranteed Return of 3%
A 95% chance to receive a return of 7% (5% chance for 0%).
A 75% chance to receive a return of 11% (30% chance of zero)
A 50% chance to receive a 25% return (50% of 0%).
Question 4: Have You Ever Played the Lottery or Gambled?
Never Give Up
Perhaps Once a year
Sometimes
The casino and lotteries are my favorite games.
What Would You Say About Your Money Management?
Sincerity is not the best policy
I am OK. I have a good budget and income but I do not save or invest enough.
Yes, for the most part. I invest and save at least 10% of my earnings
Yes, I am a financial expert on the right track to achieve my goal of financial independence
What Your Results Mean
Add up your scores based on the answers you gave above. Your score should be between 5 and 20, but it could be anywhere in the middle.
The total can be used to determine how risk-averse or conservative you should be in your investment decisions.
5-10: High-Risk Aversion
If you are a conservative investor, who can live with lower returns, then you should look for investments that offer a low risk.
You may be close to retiring and prefer security over high returns. You are attracted to bonds, CDs and interest-bearing account because they offer stability and liquidity.
While you shouldn’t completely avoid stocks, you should invest in index funds that are low-cost, passive and have low fees. You can also use a robo-advisor or financial advisor.
The mantra for your money is to get a predictable and consistent return, rather than investing in home-run businesses. Uncertainty should not be your friend.
Typical Investments
Bonds (including Treasury bills, government bonds and corporate bonds)
Certificates of deposit (CDs)
High Yield Savings (with a high interest rate)
Money Market Funds
Equity Index Funds and Exchange-Traded Funds
11-15: Moderate Risk Aversion
Risk tolerance is healthy and average.
You probably have a handle on your finances, but you’re not prone to gambling. You invest the majority of your wealth either in mutual funds, index funds or a portfolio of dividend paying stocks with the appropriate level of diversification.
You can also balance out your portfolio, which is dominated by equity investments, by investing a portion of your funds in bond funds. This is on top of having emergency funds.
Typical Investments
Equity Index Funds – Exchange-Traded Funds and Mutual Funds
Diversified portfolio of stocks
Real Estate
16-20: Low-Risk Aversion
You don’t have a high level of risk aversion and you aren’t afraid to gamble when the potential return and payoff is high.
If you are averse to risk, you can still invest in the stock exchange. However, you will also be more likely to invest in cryptocurrency or day trade stocks. You are always looking for the best investments to maximize your return.
This doesn’t mean that you should disregard caution and take on more risk. Investors who are aggressive can be savvy and pragmatist. You should always do research before you gamble or place bets.
You will probably resonate with the phrase “higher reward, higher risk”.
Typical Investments
Equity Index Funds – Exchange-Traded Funds and Mutual Funds
Diversified portfolio of stocks
Cryptocurrency
Speculative stocks
Personal Finance: Risk Aversion and its importance
It is important to understand your risk tolerance level before you can build a portfolio that meets your needs.
Personal finance is a personal matter.
You don’t have to invest in Gamestop just because your neighbor or a colleague of mine did in March!
The same is true for investing in index funds. Just because I like it, it doesn’t make it the best strategy. You should base your investment decisions on your comfort level, long-term goals, and situation.
Remember, a healthy dose of risk aversion can be beneficial. This is what keeps you from going to Vegas and betting your entire life savings to red with a 48% chance of doubling your money, but a 52% chance of coming home empty-handed. (This is a reference to roulette for those who answered “never!” to question #4! ).
You should be aware that every investment involves some level of risk. Your goal should be to minimize the investment risk, while still aiming for the best possible outcome on your investments.
Balance is the key to personal finance.
This article was originally published on Wealth of Geeks. It has been republished by permission.
