All forms of investments carry a latent amount of risk—if you don’t want to take any risk, you’ll be better off putting your money in a savings account, a hole in the ground, or under your mattress. Low risk investments typically yield low returns. Medium-risk investments will deliver medium returns and high-risk investments are expected to reward investors with high returns. The onus is then on the investor, his financial advisor, or portfolio managers to identify risk appetite and make smart investments with the best risk to reward balance.
Unfortunately, there’s no one-size-fits-all solution for getting the perfect blend of risk and reward. However, you can improve your investing game by taking the time to objectively access your feelings by measuring your risk appetite along an emotional spectrum.
Risk Appetite in relation to fear and exuberance
An investor can put of a front of willingness to take high investment risks when in actual fact they are mostly feeling exuberant based on their outlook on the market. For instance, an investor that feels good about the stock market having watched the S&P 500 gained 11.68% in the year-to-date period might mistake confidence in the economy for a willingness to take big risks.
Conversely, an investor who is a weak position financially might be afraid of making investment decisions and such fears might be mistaken for a low-risk aversion. For instance, if you made some poor personal finance choices and your credit report indicates that your credit score just took a hit. You might want to clam up and avoid taking bigger risks even though you still have the financial cushion to absorb losses on a bigger-than-average risk-to-reward investment plan.
Risk Appetite in relation to regret and pride
Regret and pride are two powerful emotions that tend to drive a large proportion of the decision-making process for humans. Pride is a pleasurable feeling on a visceral level and regret is a painful feeling on the opposite end of the spectrum. People naturally remember and want to repeat activities that boosted their pride. Conversely, they’ll instinctively shy away from activities that caused them regret in the past.
Hence, an investment in Bitcoin at the start of this year would have elicited pride as Bitcoin rose all the way from $1,100 to $4500 in about eight months. People who enjoyed the +400% gain in Bitcoin will be bold to declare how they were able to see cryptocurrencies as the future of money. However, investors who jumped on board the Bitcoin bandwagon when it was already at the $4,500 high, only to lose $1000 in three days might be filled with regret and unwilling to invest in any new technology/industry in the near term.
Risk appetite in relation to confidence and overconfidence
A portfolio manager will usually find a way to measure risk appetite by asking investors how much confidence they have in their ability to make good financial decisions. Investors who strongly believe that they can make smart financial decisions are steered towards high-risk investments while investors who are not confident in their investment prowess are steered towards low risk investments.
However, you need to be objective enough to understand when you are being confident in your investment ability and when you being overconfident. Overconfident investors tends to underestimate the latent risk in any investment. More so, they are likely to ignore advice to diversify their portfolio or hold their investments instead of jumping in and out of multiple trades.