All of the recent hype surrounding Gamestop, cryptocurrency, non-fungible tokens (NFTs), and meme stocks made me question – is anyone risk averse anymore?
Does anyone value consistent returns over the 50/50 gamble to win big or lose it all?
But still, it feels like everyone is gambling with their hard-earned income like it’s their first time in Vegas. And it’s partially true.
While many people are investing in index funds and other traditional investments, Dogecoin (crypto that started as a meme… yes, a meme) has a market cap of nearly $50 billion!
Ford doesn’t even have a $50 billion market cap.
As I felt in a hint of FOMO surrounding all of these fast-growing investments, it felt like a good time to reexamine why I’m passing on these types of investments in the first place – because of the risk they carry.
The Definition of Risk
According to Merriam Webster, the definition of risk is the “possibility of loss or injury.”
In this case, when dealing with the world of personal finance, we will focus on the first three words – the possibility of loss. Specifically, financial loss.
A high-risk investment has a high probability of declining in value, resulting in you losing money. High-risk investments include things like equity, NFTs, and cryptocurrency.
Naturally, a low-risk investment has a low probability of declining in value. Low-risk investments include bonds and certificates of deposit (CDs).
And then you have everything in the middle, like real estate.
Though, risk is not a binary measure… the other variable to consider when determining risk is time.
The longer you hold an asset, the less risky it gets (usually). For example, in any one year, the S&P 500 could go up or down by 30%. So that is a pretty risky option.
However, over a long period of time, it gets less risky. You can be relatively confident that the S&P 500 will average a return of +5-10% per year over most 20 year time spans.
That’s why when you are 20 or 30 and just start investing; it makes sense to invest in equity. You have a long time horizon over which you will be investing.
When you get close to retirement and need your money in the next few years, it likely makes sense to adjust your portfolio allocation to more conservative investments. Because your time horizon is shorter, investments, in general, get riskier.
Risk Averse Definition
Risk aversion is defined as avoiding risk. Pretty straightforward.
If you are a risk-averse investor, you will seek out investments with a low probability of declining in value. This is because you value preserving your money more than seeking out the best possible return.
And, of course, the tradeoff with being a risk-averse investor is that you will not get crazy high returns on your money. Instead, you will receive smaller but consistent and positive returns.
On the flip side, somebody who is not risk-averse prioritizes finding the best possible return over finding safe investments.
How to Know How Risk Averse You Are: Ask Yourself 5 Questions
I developed a quick 5 question quiz to help determine your level of risk aversion.
Some of these questions have subjective answers, and others are objective. Regardless, all of them will help you figure out what risk level you can accept, which is helpful to know when building your own investment portfolio.
Question 1: How Close to Retirement Are You?
- 0-5 years away
- 6-10 years away
- 10-20 years away
- 20+ years away
Question 2: How Big is Your Emergency Fund?
- I Don’t Have One
- 1 Month of Savings
- 2-3 Months of Savings
- 3+ Months of Savings
Question 3: Of the Following, Which Would You Choose for Your Investment Returns This Year?
- A guaranteed return of 3%
- A 95% chance of receiving a 7% return (5% chance of 0%)
- A 75% chance of receiving a 11% return (30% chance of 0%)
- A 50% chance of receiving a 25% return (50% chance of 0%).
Question 4: Do You Ever Buy a Lottery Ticket or Gamble?
- Maybe Once a Year
- Every Chance I Get, I love lotteries and the casino
Question 5: In General, Would You Say You Are Good with Money?
- To be honest, not really
- I’m OK – I have a basic budget and a good income, but I don’t save or invest as much as I would like to
- For the most part, yes. I save and invest at least 10% of my income
- Yes, I’m a money expert and on track for my financial independence goal
What Your Results Mean
Now, add up your score based on your answers above. You should get a result somewhere between 5 and 20.
You can use the total to get an idea of how risk-averse you are or should be when investing:
5-10: High-Risk Aversion
You are a risk averse investor who is OK with lower returns and should seek out conservative investments.
You are likely close to retirement and value security over high potential returns. Bonds, certificates of deposit (CDs), and interest-bearing accounts appeal to you because of their stability and liquidity.
And while you don’t avoid stocks altogether, when you invest in them, it’s in low-cost and passive index funds. You might also seek out the help of a financial advisor or robo-advisor.
Your money mantra is all about getting a consistent and predictable return over seeking out home-run investments. Uncertainty is not your friend.
- Bonds (including government bonds, treasury bills, corporate bonds)
- Certificates of Deposit (CDs)
- High Yield Savings Account (with a good interest rate)
- Money Market Funds
- Equity Index Funds and Exchange-Traded Funds (ETFs)
11-15: Moderate Risk Aversion
You have an average and healthy amount of risk tolerance.
You likely have a good handle on your personal finances but are not the gambling type. While you invest the vast majority of your wealth in stocks, it’s either in index funds and mutual funds or in a portfolio of dividend-paying stocks that have the right level of diversification.
You also probably balance your equity-heavy portfolio by investing a small portion of your money into bond funds. Of course, that is in addition to having cash on hand in an emergency fund.
- Equity Index Funds, Exchange-Traded Funds (ETFs), and Mutual Funds
- Diversified Prtfolio of Stock
- Real Estate
16-20: Low-Risk Aversion
You are not very risk-averse and are not afraid to gamble if the expected return and potential payoff are high.
While you may still invest primarily in the stock market if you have a low-risk aversion, you also have a high probability of investing in cryptocurrency and even day trading stocks. This is because you are constantly seeking out the best investment opportunities to maximize the return on your money.
Though, this doesn’t mean you throw caution out the door and that you are risk-seeking. Aggressive investors can still be smart and pragmatic. When you do gamble and place bets, you do your research and pick wisely.
The phrase “higher risk, higher reward” likely resonates with you.
- <li>Equity Index Funds, Exchange-Traded Funds (ETFs), and Mutual Funds
- <li>Diversified Portfolio of Stock
- <li>Speculative Stocks
Risk Aversion: Why it Matters in Personal Finance
Understanding your level of risk aversion is a valuable step in ensuring you build an investment portfolio that suits your needs.
After all, personal finance is… personal.
Just because your neighbor, friend, or work colleague invested in Gamestop back in March doesn’t mean that you should too!
Similarly, just because someone invests only in index funds doesn’t mean that it is the absolute best strategy for everyone (although I think it is a good one!). It would be best to make investment decisions based on your specific comfort level, situation, and long-term plans.
And remember, having a little bit of risk aversion is healthy. It’s what stops you from flying to Vegas to put all of your life savings on red for a ~48% chance to double your money and a ~52% chance of going home with nothing (this is a roulette reference for anyone who answered “never” to question 4!).
However, you have to keep in mind that all investing involves some amount of financial risk. Therefore, your goal should be to minimize that investment risk while still seeking the best possible outcomes on your investments.
Like many things in personal finance, it’s all about balance.
This article originally appeared on Wealth of Geeks and has been republished with permission.