By Dr. Bruce Kuhlman, CFA, CAIA
Published May 2014
Is skydiving one of your favorite pastimes? Or are you like me, and would never even consider jumping out of a perfectly good airplane? Your personal reactions to everyday (everyday?) events like this could clearly indicate your willingness to take risk, and that includes investment risk.
It turns out that all investors, whether professionals or amateurs, have both a willingness and an ability to take risk. Your ability to take risk is determined by several fairly measureable factors, such as your age, your income, your current wealth, and your desire to accumulate an estate to pass on to your heirs.
Your willingness to take risk, on the other hand, is determined by your psychological characteristics. For example, someone who is willing to jump out of an airplane might, by his or her very nature, be willing to take risk. (Of course, that depends on whether the individual realizes that there are at least two possible outcomes to jumping out of an airplane!)
Although there is more to it, investment risk can be thought of as the potential for losing money. When you invest in the stock market, for example, you could make a lot of money, make some money, break even, or lose money. It's the associated uncertainty over the outcome of the investment that most people think of as risk.
Some people are driven by positive expectations. In their minds, the potential for making money in the market outweighs the potential for losing money. They tend to focus more on the upside. Others might steer clear of the stock market, as they consider it to be overly risky. These people tend to focus primarily on the downside. You can see how your general psychological disposition toward risk can affect your investment choices. If you are extremely averse to taking risk, you will most likely put your money in investments you think of as very low risk, such as U.S. Treasuries.
Your ability to take risk is determined by much more objective measures. Put bluntly, the more you have, the more you are able to lose before it really hurts. A successful executive with a steady salary, for example, might be able to accept significant investment risk. The executive is fairly confident that his salary will continue to meet his everyday needs, even if the investment portfolio loses money. However, if the future of the firm and the executive's salary become doubtful, the executive is no longer able to take as much investment risk. He starts to feel that he might have to rely on the investment portfolio to "pay the bills."
The ability to balance the investor's ability and willingness to take risk makes the investment advisor invaluable. Left to their own devices, most investors will tend to invest according to their willingness to take risk. People who jump out of airplanes, for example, might want to invest in all the latest stock fads. The result could be large, unexpected investment losses and a related inability to meet future goals, such as retirement spending. The overly risk-averse individual, on the other hand, might not be willing to take enough risk. The result in this case, although not as dramatic, could be the same. A retirement portfolio that isn't sufficient for meeting retirement spending.
The bottom line is that to generate wealth through investing, whether in the stock market, in real estate, or in any other form of investment, return is positively related to risk. Earning any investment return entails taking risk. To make larger returns the investor must generally be willing, and able, to take greater risks.
Bruce Kuhlman is a full-time faculty member at Purdue Global. The views expressed in this article are solely those of the author and do not represent the view of Purdue Global.