If you have an investment adviser, you’ve probably been asked to rate your risk tolerance from one to 10. Or maybe you’ve been questioned about what your actions will be during the next market crash: Will you panic and sell or buy more?
I don’t know many investors self-aware enough to admit they will indeed engage in panic selling. Likewise, most investors don’t sit around with a pile of cash waiting for a market crash — the last crash was in 2008, so those investors have been waiting a long time. Besides, what did you do during the depths of 2008? Regardless, you’re now 11 years older and in a different place. Evaluating risk tolerance with simple abstract questions is not useful.
Risk is powerful, but most of us are more accustomed to thinking about returns. Of course returns matter. But we can’t judge our returns without understanding the risk we have taken. Unfortunately, most people don’t have the slightest understanding of risk.
To Test Yourself, Flip a Coin
Here’s my test to start thinking about risk. Imagine all of your money stacked in bills on the desk in front of you. Now you are now looking at the largest stack of bills you have ever seen. We will play a game to determine how your money does over the next 12 months. Your job is to choose between picking up one of two coins: a nickel and a quarter.
If you choose the nickel, go ahead and flip it in the air. If it lands on heads you will be up 5%. However you will be down 5% if it lands on tails.
The stakes change if you choose the quarter. If it lands on heads, you will be up an impressive 25%. And tails? Well, you’ll be down 25%.
With all of your money on the line, which coin do you pick up? And more importantly, what does this tell us?
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