Ideas about risk that we have totally wrong

I’ve been reading Aswath Damodaran’s book Strategic Risk Taking: A Framework for Risk Management. It’s a great read and I reluctantly had to put it aside while guests where here; I’ve just picked it up again and am continuing to devour it; I read some of the book and then reflect on how it impacts my business, my clients’ businesses, my readers’ businesses, and my thoughts of the capital and real estate markets… and then I read some more.

As I’ve been reading, I keep coming back to the idea that people can get pretty screwed up when it comes to risk. We think we’re risk averse, and sometimes we act that way, but other times we make decisions that are explicitly (or implicitly) risk-welcoming.

Here are some that I see frequently. (And believe me, I’m not judging people who think these things because I myself face some of these same ideas!)

  • Buying stocks high instead of low and selling low instead of high: Investors see stock prices really low and decide to wait and see if the price goes up before they buy. This mindset is a problem because investors need to buy low and sell high but all too often, investors (especially amateur investors) wait until the stock is high before they buy (because, in their mind, the high price is confirmation that the stock is worth buying). The same is true of stocks that investors hold: They should sell high but instead they see the prices declining and they want to cut their losses so they sell low. We all KNOW that we are supposed to buy low and sell high but we often do the opposite.
  • Buying properties: The same thing happens with properties. Homebuyers may feel that prices are too low to buy (perhaps because they are expecting prices to continue to decline?) and they’d rather wait for prices to go up. But rising prices can make some houses unaffordable. It’s better to buy when the prices are low.
  • Timing the market: Similar to above, many investors try to time the market. They know they’re supposed to buy low and sell high so when the stock is low they think it might keep going lower so they don’t want to buy right now. They wait. The stock goes down. Then the stock goes up. Then the stock goes down. Then the stock goes up. A stock “bottom” shouldn’t be thought of as the lowest point but rather it should be thought of as a window in which the stock price is low.
  • Investing in crazy things: Many investors would say they are risk averse when investing in the capital markets. They buy mutual funds or blue chips because their financial advisor tells them to and they claim to be careful with their investments. But then they hear a “hot tip” from their neighbor about an amazing biotech IPO and their whole risk-aversion flies out the window.
  • Buying lottery tickets: This one is really fascinating to me. If you were to ask someone to throw away a couple of bucks into the trash everyday, they would think you are crazy. And yet, people spend a lot of money in lottery tickets every week without considering the odds.
  • Wanting to quit a job but being willing to take the risk: Wow, I see this so often! People who want to quit their job (because they hate it or their salary is capped or they want some freedom) but they can’t handle the small risk of an unknown paycheck. The weird part is, there are many things they can do in the interim period as they build a small start-up before they quit their job but they just don’t do it. They’re content to watch TV in the evenings and go to work during the day and dream… but that’s it.
  • Wanting to grow a business but not wanting to risk anything: I see this one a lot too! Business owners who start a business and want to grow it but aren’t willing to invest anything into their business. So you get people who want to market their business but they hire the cheapest non-English-speaking writers to create their marketing and then wonder why their marketing isn’t connecting with clients. Or business owners who know they should build a mailing list but don’t want to invest in the software to get them there.
  • Investing in the wrong things: I see this one a lot among real estate investors — they invest tens of thousands of dollars into training over decades but won’t take the risk of doing a deal. (One of my clients calls these people “7 year newbies”).

In all of these examples, you can see how we approach risk in a puzzling way. We claim to be smart about risks but then we act inconsistently, sometimes choosing the risk-averse way and sometimes choosing the risk-accepting way (and sometimes being too much of one or the other)… and often doing the opposite of what we should be doing.

Is there a solution? I don’t think my one measly blog post is going to erase thousands of years of questionable risk judgement. However, whenever faced with a decision that involves risk, we should ask ourselves how we should be acting and compare it to how we really do act and then try to figure out why there is often a difference.

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