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The Big Fight – Risk versus Benefit

The idea of risk is fascinating. Think about it. Risk is so much a part of everyday life that we cannot avoid it. It’s just not possible.

Even in the first few minutes of waking up each day we encounter a multitude of risks from slipping on a wet bathroom floor, to burning the house down when we use the toaster. 

Psychologists in the 1970s were very keen on experimenting with risk, so study after study looked at how we react emotionally and rationally to threats and opportunities.  What they found is that human beings are spectacularly bad at making the right decisions when faced with choices of varying degrees of risk.

For example, there is always a surge in people buying insurance against natural disasters in the immediate aftermath of things like earthquakes or tornadoes.  Even though this is the very time when the risk of the natural disaster happening is at its lowest. 

Similarly, most people would tell you that playing the lottery is probably a better way to win money than playing roulette.  When in actual fact the probability of picking five of the six correct numbers in a lottery is just one in 2,330,636.  Whilst the probability of putting your money on the winning number if you play roulette is a much healthier one in 36.

From the multitude of studies carried out it looks very much as though the human brain reacts in a number of ways when trying to make decisions, but essentially we allow our emotions to rule, and find it hard to listen to our rational selves.

And this is never more true than when it comes to investing.  We tend to get carried away by the promise of massive returns, the excitement of turning a small amount of money into a big pot of money, and so sometimes take bigger risks than we ought to. 

Or we tend to think that if the professional giving us advice about where to invest our money looks nice, sounds nice and shows us nice pictures of his cute new puppy – well then, the investments he’s recommending must be good.  So we sign the cheque because we like the person selling it to us, rather than because we’ve given due consideration to the risks involved.

It seems crazy when you look at it like that doesn’t it?  In fact, there’s a whole area of study on it called Behavioural Investing, which we will be looking at in another article.

But if we stick with the idea of risk for the moment, and particularly risks in terms of investments, how do we ensure our rational head has the information it needs so that the risks can be weighed up against the benefits and we therefore invest our money wisely?

The Big Fight – Risk versus Benefit
Generally speaking the higher the risk the greater the potential benefits.  And the lower the risk, the lower the potential benefits.

If you come across an investment offering a 50 per cent return, then the chances are that the risk of losing your money is quite high. 

Compared to a bank savings account that will probably only offer around 0.5 per cent returns, but it’s perfectly reasonable to just assume your money will be there when you go to withdraw it.  And you’d be incredibly surprised it if wasn’t.

The old adage probably always holds true when it comes to investments.  If the promised returns look too good to be true, they probably are.  And if you choose to invest your money you’re taking a big risk.

Old and Young
When we are younger, although we probably have less spare money to invest, we are more able to put our money in higher risk investments.  This is simply because if we lose the lot then we still have many years in which to make up the loss before we retire and need our nest egg.

Conversely, an older person typically has a larger investment portfolio, but if a loss occurs they have less ability to recover, as they have much less earning potential left.

If you look at it like this then the way you invest should change as you get older.

Once we decide what is required for us personally then as a rational human, we should want to take the least risk for any given level of return.

Mixing the Ultimate Martini
Just as the ultimate martini should be the perfect balance of vermouth, gin, lemon and ice, so your investment portfolio should have the right ratio of higher and lower risk investments.

We all know putting all our eggs in one basket hardly ever works.  So you shouldn’t rely on one investment if you can help it.  The better option is to spread your risks.  Better to save a little in a number of investments – maybe one being riskier than others but with the hope of higher returns.  Rather than in just one lower risk investment offering lower returns, or just one high risk investment where you might lose all your money.

Know the Risks
Perhaps the most important thing to remember when assessing risk is to find out what the risk(s) actually are.

Don’t sign your money away to any investment without first assessing where the potential risks lie.  For example, if you are looking at a property-related investment then do some research about the property market.  You may not be an expert and you certainly can’t tell the future, but information can help you assess the potential for an upswing or downswing in the market, and thus what risks there are for your investment.  

And this is the same for any investment you are making in whichever industry. Information is key to ensuring you have a good grasp of the potential for success.

Also, look at the structure of the investment product to see how risks are being mitigated.  What measures are being taken to protect your money?  We look at this in more detail specifically in relation to peer-to-business lending in our article about security.

Risk is all around us every day.  But just as our rational head tells us its worth taking the risk of using the toaster to make our breakfast, so we can use our rational head to make the right investment choices.

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* figure taken from the RAC Foundation

** ONS figures reported in The Guardian 28th October 2011

*** figures taken from Health and Safety Executive

 

April 2015