If you can’t get comfortable with risk, opportunities to grow your wealth are greatly reduced. Because when it comes to investing, the bigger the risk, the bigger the reward.
“When confronted with the sharemarket moving up and down, there’s a perception that it’s just too risky,” says Julia Lee from Burman Invest. “There’s a reason behind this: the prospect of losing is about twice as powerful as the pleasure of gaining.”
People are generally more willing to take risks to avoid a loss, than to make a gain. In other words, we feel the loss of money when a share price goes down far more than when that same share price goes up. In fact, the share price would need to rise twice as far in order for us to feel compensated for the original loss.
“Understanding this very human quality of loss aversion could be the key to becoming comfortable with risk,” Lee says.
WATCH Julia Lee’s segment on the show and then read on for more.
Low risk tolerance can lead to bad decisions
It’s not surprising then that any loss on the sharemarket can cause us to behave irrationally and make bad decisions. These poor decisions (holding onto shares for too long, or panic selling them) can compound the feeling loss. This creates a vicious cycle as it reinforces our original bias that the sharemarket is “just too risky”.
The fact is, if you want to grow your wealth, you need to get comfortable with risk. “When it comes to investing there’s definitely a trade off between risk and return,” says Lee. “The lower the risk, the lower the potential return; the higher the risk, the higher the potential return.”
As Lee points out, if you don’t embrace risk, you may as well just park your money in a “boring bank account”. Bank accounts carry minimal risk, but they also carry minimal return on your investment, if any.
How to be more comfortable with risk
So, how can we grow our tolerance and get comfortable with risk? Here are a few strategies to try, while keeping in mind that the best strategy of all is to talk to a financial adviser about your own particular risk personality and circumstances.
1. Understand the market
Education and information are always going to top the list for reducing your risk aversion when investing. The more you can research and understand the companies you’re investing in, the more comfortable you’re going to be. For a general overview of the market, a good place to start is listening to Kochie’s The Call podcast. Each week two experts deep dive into ten different stocks and share their thoughts on why they’re a good or bad investment. It’s a fast-track way to educate yourself on what you should be looking for.
Other ways to get to know what’s out there are reading the RBA’s Statement on Monetary Policy, financial papers and websites, signing up for Kochie’s weekly newsletter, following fantasy stock portfolios and work through the ASX free online courses.
2. Understand your goals
“Most people when asked about what they’d like from their investments usually answer something like ‘make lots and lots of money’,” says Lee.
A noble goal, for sure, but defining how much and by when matters if you want to get comfortable with risk. Are you after capital growth over time, or a quarterly income from dividends? Are you seeking tax advantages on long-term capital gains? The answer to these questions will also determine the type of risk you may be willing to take on.
The fact is, if you want to generate impressive wealth, you need to accept that there will be some equally impressive uncertainties involved. You don’t necessarily have to learn to surf the sharemarket’s inevitable short-term highs and lows. That kind of ride is way too volatile for most of us. Instead, you can swim in calmer waters by setting both short and long term goals for your money. That way, your long term investments will hopefully be smooth enough to settle some of the short-term choppiness along the way.
3. Play it safe
If you generally have a low tolerance for risk, putting all your money into start-ups is probably not going to suit you. Investing in established blue-chip companies will be more suitable. The returns may be lower, but so is the risk.
You can also protect your portfolio by diversifying across many different stocks. Spread your investments between different industry sectors, different companies and even different fund managers. Diversification reduces the risk if one business or industry performs badly. No matter what the economy does, some investments are likely to benefit.
4. Face your fears
It’s an old trick, but a good one. Ask yourself “what’s the worst possible thing that could happen?” In investing, the worst-case scenario is most likely, “I’ll lose everything.” Okay, there we go, you’ve lost everything – now what?
Rather than catastrophising this scenario, start thinking of it in a rational way. What’s the likelihood of it happening? (Incidentally, in 2020-2021 there were 10,621 new personal insolvencies in Australia – a 30-year low.)What would you actually do if you lost everything? How would you feel? Who would you tell first? What would you do next? Are there options still available to you? What would starting again look like? Would you do things differently next time?
Responding to your worst fear in this way can help diffuse its power. It can also help increase your tolerance for risk because you’ve worked out that you can survive whatever happens, no matter what.
5. Take it slow
By learning more about the market, defining your goals and playing it safe to begin with, you will hopefully start to feel more at ease with risk. Bit by bit, you can grow your tolerance and explore more of the investment opportunities available to you. Practise by taking smaller risks and see where they lead you.
Remember the golden rule, the higher the risk, the higher the return. “When it comes to investing, understand risk, embrace risk and use it,” advises Lee. “Because without it, investing would be similar to leaving your money in a boring bank account.”
This article contains general information only. It should not be relied on as finance or tax advice. You should obtain specific, independent professional advice from a registered tax agent or financial adviser in relation to your particular circumstances and issues.