How To Get Better At Risk Taking
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today's episode 394, it's titled, How to Get Better at Risk-Taking.

I recently received an email from a listener. She writes, I appreciate your knowledge and sharing what you know. I'm a plus member and I'm hoping you can ease some of my concerns. I've been getting a ton of the market is going to crash emails. Several mentioning China taking over Taiwan. Market drop predictions of 80%. I know you can't read the future, but I'm wondering if there is anything you can tell me that might help calm my panic.

In today's episode, we're going to take a look at risk-taking, risk aversion, loss aversion, and how to better manage risk and be willing to take risk. We'll look at some of her specific concerns with China and 80% drops, but also step back a little bit and look at some principles for how we can be better at managing risk and taking risk.

First, no one knows whether the stock market will fall 80% or not, or China will invade Taiwan. Only their senior leadership knows that. And maybe they don't even know if and when they will do that. Now, there are some things that we can look at in the case of China potentially invading Taiwan that suggest it's unlikely in

in the near term. I was first exposed to Taiwan in the sixth grade. We did lengthy reports on different countries, and for whatever reason, I chose Taiwan, probably not the best country to choose because their history was very confusing, at least to me as a sixth grader, with the Republic of China having, led by Chiang Kai-shek, fighting the Chinese Communist Party, and Chiang Kai-shek having...

taken the Republic of China into Taiwan, and there's been this dispute ever since the 40s. One of the economic services that I subscribe to is Capital Economics. They point out that an amphibious assault on Taiwan by China would be a huge undertaking, requiring the buildup of troops, ships, and equipment on the coast opposite Taiwan. It

It would take many weeks to do that, and we're not seeing that happen. In addition, the weather in the Taiwan Strait, it's frequently stormy, windy, and foggy. And experts on this estimate that really there's only two time windows that would work for an assault on Taiwan, late March to the end of April, and late September to the end of October. And so we can sort of see, or experts can see, is there any buildup of

military forces to invade Taiwan. In addition, there's some heavy disincentives for China to do that, particularly warnings from the government. Now, the U.S. has never said that they would intervene in China's invasion of Taiwan, but the U.S. government did sign the 1979 Taiwan Relations Act, which states that they would ensure Taiwan has the ability to defend itself. The

The other consideration is China already has a lot going on this year. It's the party Congress later this year. China is dealing with COVID and

and trying to get their economy up and running again. Their year-over-year GDP growth through June, the official figures are about a 0.4% increase, but many economists that study China, including capital economics, suggest in reality year-over-year economic growth contracted because of the zero COVID policy.

China's dealing with a housing crisis as there are citizens that have banded together, not paying their mortgage until their house that they bought gets finished. And finally, China doesn't have a reason to act now to invade Taiwan.

They continue to build out their military. Right now, they have 355 naval ships. They're expected to have 420 in 2025. And it's quite possible they'll continue to wait until there's no urgency to invade Taiwan currently. Doesn't mean they're not going to do it. And we don't know what would happen after that. That's one of the uncertainties that exist in the world.

There's a difference between risk and uncertainty. Risk is where there's a narrow range of potential outcomes, and the probabilities can be estimated, and we can purchase insurance protection. So the fact that we might die prematurely, we can buy life insurance through someone resigning.

like Policy Genius that can help us compare. We could get into a car accident. We can buy auto insurance. The stock market might fall 80%. It's possible to estimate the probabilities of that based on history and purchase insurance. Now, that insurance through a put option can be very expensive because stock markets are volatile, but it is a risk.

Now, with uncertainty, there's a wide range of potential outcomes. We are uncertain about what will happen in the future. What unpredictable political events, weather events, employment events in our own situation, social events, all these potential things that could happen. Now, one, and it is in a wide range of outcome, is China could invade Taiwan.

or they might not. But it's very difficult to assess a probability because there is no history of that. When we look at the history of the stock market, we can estimate the risk of a market loss based on several hundred years worth of history and a very solid data set for the past hundred years. But with invasions, there isn't that much historical data to put a probability. If you do, we're just making it up, essentially.

Now, when we look at the potential for an 80% decline in the stock market, again, we don't know, but it would probably happen or it could happen if we had a very deep recession and we continued with a very high inflation, so a stagflation type scenario. Right now, central banks are combating inflation by raising their policy rates. That has led to higher longer-term interest rates, a

Eventually, hopefully, that will bring inflation down, but we don't know, will a recession occur as part of that? And again, yeah, the market could fall 80%. We've already had a decline if we look at the MSCI All-Country World Index year-to-date through yesterday, July 18th, down 19.7% year-to-date. We've survived that. Most of us are not ruined because of a 20% loss.

When we look at emails we might get predicting dastardly things, if they're very, very specific, we should always be cautious.

Investment experts tend to be humble and they don't tend to fear monger and talk in very specifics. Now, if there are some predictions that we want to understand what are driving those predictions, what has to happen and how plausible is that? Often it's better just to have a filter and

and not receive information from people we don't trust that continually are predicting dire things. But most investment experts would not be predicting something as specific as China invading Taiwan, leading to an 80% drop in the stock market. But as we look through that, we want to understand, okay, what exactly are they getting that information on? Don't run away from it, but we can at least explore it and put it into context.

Now, how do we manage this risk? Another PLUS member sent me a research piece by Joaquin Clement that he did for the CFA Institute. And it was about risk management, risk tolerance. And he pointed out a very important point, that there's a difference between risk capacity and risk aversion.

Risk capacity, or we could call it uncertainty capacity, or loss capacity. I actually like the term loss better because we can suffer losses from uncertain events that happen or risky events that happen where we could have estimated the probability. So if we think about our loss capacity, that's our ability to withstand a loss. Depends on our economic circumstances. It can depend on our time horizon that we might have

have before we retire and need to tap into our assets.

Our loss capacity is affected by our income. If we have high income and we're saving a lot, our ability to withstand losses is greater. Our loss capacity really comes down to how likely will we be ruined if something catastrophic happens? How much of a buffer do we have? I have a friend that I've gotten to know over the last few years who has had just a

a really, really rough time the last three years. Her husband passed away. Her ex-husband passed away. She's in her 60s. Recently, as I was talking to her, her son was ill, her adult son, who helped support her. She gets about $880 a month on Social Security, and her rent is $550 a month. So only several hundred dollars a month to pay for utilities, food, etc.,

very, very small buffer. And we've obviously have helped out some, but her son passed away and she was devastated. And I obviously couldn't console her when I talked to her, but her loss capacity is very small because of all of these horrendous events. Others have a wider loss capacity. And hopefully over time, as we build up our income, as we save, as we build up our buffer, our

ability to withstand losses is greater. That's different from risk or loss aversion. Loss aversion is our psychological or emotional response to loss, our regret. We experience regret when we lose money or lose anything, and the degree that it impacts us varies by person. I saw one academic study that

that they estimate that 50% of the population is loss-averse, so very high loss aversion, but 50% are loss-tolerant. They're willing to accept losses. In fact, some of them are.

Some, based on their study, are willing to accept negative expected values, what we call gambling, something with a negative expected return. They're willing to do that. They found in their study that loss-tolerant individuals tend to have more assets invested in stocks. They're more likely to have recently gambled and are more likely to have experienced a financial shock in the past.

But they also tend to have lower overall assets. And the authors believe a plausible explanation for this is loss-tolerant individuals become habituated to repeated losses. They see losses all the time. They get used to it and they're willing to take bigger risk because of that. They also found that these loss-tolerant groups tend to have lower levels of education, less cognitive skills, and lower incomes.

as well as lower financial assets. And that gets a little, this is based on their study, but it's certainly something to consider as individuals become more educated, as their income increases, they tend to be more loss-averse and risk-averse.

Our degree of loss aversion in looking at other academic studies, it's our genetic disposition. Oftentimes, just that's the way we're born. But it can also be impacted by our experiences. I was thinking back to when was the first time I felt regret for a loss. And it's a small thing, but I remember walking occasionally my parents and

And I, this is when I was real young before my parents split up, probably three or four, we would walk to a local Cincinnati store called United Dairy Farmers and we would get ice cream and we'd get milkshakes. I liked vanilla milkshakes. I remember walking home with that, probably only a block from my house, and the milkshake fell out of my hand. And by then it was nearly melted and it spilled all over the sidewalk.

I keenly felt that. Like that was a loss for me because I didn't have any income and I lost my milkshake and it felt terrible. It felt worse losing that milkshake than when I've lost tens of thousands of dollars in investing. I felt loss when I had a pack of 10 croissants

These supposedly magic, super special, hard crayons that were indestructible, according to the television ads that ran on Saturday morning cartoons. So I proved it to see and dropped the crayon from the top of the stairs down to the cement basement floor and it broke. I regret that. It felt terrible, but that was a loss.

My loss aversion increased throughout my teenage years. I did a number of entrepreneurial ventures, running classified ads to do handwriting analysis to provide research services. They

They all failed. Maybe I can't say I got habituated to failing at business, but I certainly felt it. So when I do other businesses, I try to make sure that no particular loss will ruin me because I know that business doesn't always work out. Investing-wise, my experience through losses, managing assets through the Asian financial crisis of 1997, the internet bubble crash of the year 2000, the great financial crisis in 2008.

The longer I invest, the more I realize I can't predict what's going to happen and I have to manage through this uncertainty. And as a result, my loss aversion has increased as I've gotten older and wealthier. Before we continue, let me pause and share some words from this week's sponsors.

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Live in the ring. Don't miss the Harlem Globetrotters on March 8th. A slam dunk of fun for everyone. Tickets are on sale now at CapitalOneArena.com. Don't wait. Grab your seats tonight and secure memorable moments for your whole family. Our degree of loss aversion then is based on genetics. It's based on our experience, but it's also based on our community. There's studies that show that people that live in less politically stable countries with

with a lower level of social cohesion, and examples that they point out is Russia, Romania, and Greece, that those individuals tend to invest less for the long term and have a higher preference for quick gains. You compare that, according to this study, with citizens of Germany, Switzerland, and Scandinavian countries, they show a higher propensity to invest in the long term. In Sweden, I remember seeing stands of trees that are...

were planted and wouldn't be harvested for 70 to 80 years. One generation planted those trees for the next generation. Very long-term thinking. But our community, the way that we grow up, can affect how we invest and our degree of loss aversion. Additional influences on loss aversion based on a search of studies, academic studies, is even climate change. One study,

Looking at participants in Indonesia and Mexico, individuals that saw a greater increase in the lifetime average temperature and average precipitation saw a significant decrease in their risk aversion. They were willing to take more risk as the climate got warmer and wetter.

On the other hand, they found that when there was a great deal of volatility in temperatures in Indonesia or volatility and precipitation in Mexico, that individuals that experienced that tended to have greater loss aversion, were more wary of taking risk. Other studies showed that even our mood, a study in India of 782 individuals over age 18 found that a

A negative mood state increased the propensity to take financial risk. The reality is then we each have a degree of loss aversion that's influenced by our genetics, our experiences, even our climate, our community, and that can vary over time.

We have to weigh that risk aversion, that regret that we feel with our capacity to withstand losses. And there's always a balance trying to figure out, well, how much risk should we take?

The economy, though, overall needs risk takers. I read an interesting essay by Savakis Savides. He's really a risk academic that has taught about risk, has studied risk, certainly its impact on the economy. He provides a definition of investment that's a little narrower than we've used on the show and in my book.

We've defined an investment as an opportunity with a positive expected return, a gamble with something with a negative expected return, and a speculation, something where there's disagreement whether the return will be positive or negative. Savita's more narrow definition of an investment is capital that is used to fund a project in the real economy that is seeking to create wealth and has a return on

on that equity investment. So it's an equity investment in a new business where there's risk. And if things turn out, then new wealth is created and there's a positive return. He points out, though, that there's no return without risk. The risk being that the project fails to achieve the required return. But it's these projects that drive innovation, productivity increases, which is what leads to the growth in the economy, right?

Right now, for example, there's about $500 billion of dry powder venture capitalists own. They've raised funds. They have about $500 billion that could be invested in new startup opportunities or follow-up investment in existing startups. Public companies raised funds.

a trillion dollars in 2021. These would be initial public offerings or secondary offerings by public companies, and that capital could be invested in projects, risky projects that may or may not work out. Savides contrasts this investment, equity investments in capital projects, with projects with what he describes as rentiers, R-E-N-T-I-E.

An example of something that's earning a return basically through rents are asset-backed securities. These are bonds that are backed by existing assets. Could be mobile homes, could be auto.

He writes,

just collecting the interest on assets that were already in existence. And then as I thought about this and went through different investments, what we call investments, let's call them investment securities, bonds, is bonds...

An investment or is it just rent seeking? Depends on what the money is used for. If it's a government bond or a corporate bond that they're issuing a new bond to pay off existing debt, then that's just very much an asset transfer. But if that debt was used to fund a capital project, a new initiative, then it could be considered more of an investment. What about stocks that trade in the secondary market? You go buy a stock internationally.

in Amazon. Is that funding new projects at Amazon? Not directly, but as a stock owner, we're an owner of the company and the management can pay a dividend or they can invest some of those earnings in new projects, perhaps do follow-up offerings. But it's not necessarily really clear. But Savideh's point is that in the capital markets, we need risk takers. We need

investments where there's a potential risk of loss in order to foster innovation and productivity increases. And as he mentions, as income inequality increases, that actually leads to more risk aversion, more loss aversion, as wealthier investors want to protect their existing capital and are less likely to initiate investments.

What potentially we should do as our wealth increases, and I try to do this, as my risk or loss capacity has increased and my loss aversion, I do designate a portion of my assets for risk-taking. It's about 20% of my net worth is in private capital, which is a lot of money.

which includes venture capital and includes some energy investments. There's some private real estate in that, some buyouts, but it's risk capital and it's capital that it's at risk. Now, it's highly diversified among a number of different underlying partnerships with hundreds of different investments. And we've talked about that in episode we did, it was late last year, on investing in startups. Better to have a

a lot of different startup investments because most won't work out, but some will, and hopefully those gains will offset the losses in the other categories. But as individuals, we don't want to completely eliminate risk so that we can contribute to a productive economy. We also want to focus on increasing our loss capacity, our ability over time, build up that margin of safety, that buffer,

take prudent actions to protect against the downside so that we're not ruined. So that overall, if our risky portion of our portfolio suffers deep losses, we won't be ruined. That's how we can balance it. Perhaps in that risky portion, that if it suffers major losses and doesn't ruin us, we can invest in the startups of family members or friends.

So those are the first two things we can do. We can increase our risk and loss capacity. We can segment out a portion of our portfolio, a barbell strategy where we have less risky assets, but an element of our portfolio where we're willing to take risk so we can contribute to more innovation. A third thing we can do is learn from our losses. How did it feel when we

We made a risky investment and it didn't work out. Do we survive it? Do we find the pain diminishes over time? I know when we lost close to $100,000 on the house that we built in 2005 and sold in 2013, it stings. But over time, hey, we've made it up in other real estate investments, more than made it up. But we can learn from those losses and realize we did survive. It didn't feel very good. But over time, that loss diminished.

Now, we don't want habitual losses to where we just suddenly say, well, we're always going to lose, so we're just going to risk it all. A barbell strategy is more appropriate.

A fourth thing we can do is just don't listen to fear mongers. Focus on the things we can control. Diversify our portfolios with multiple return drivers. Focus on building our human capital, our skills, so that we're more flexible in the face of uncertainty. We can do different jobs, be more nimble in that regard.

we can focus on building our knowledge of asset classes. As we become more confident investors, learn how asset classes work, learn how to build out portfolios, learn how to dissect fear-mongering emails to realize they're way too specific, that they're not humble enough, that they're not likely to be right because of that specificity and lack of humility. As we gain knowledge, we become more confident and more humble.

We can also filter out the information that we receive and only get information from trusted resources. A fifth thing we can do is just recognize that our loss aversion can change over time and that some of it we just can't change. It's our genetic disposition. And don't beat ourselves up if we find that we're just more risk or loss averse than somebody else.

They've had different experiences. We can focus on building our lost capacity and then be willing to take some risk, but recognize that the degree of risk that we're willing to take might differ from someone else. And finally, we don't want to confuse risk with uncertainty. We can protect against risk if we choose. Narrower range of outcomes, probabilities known. Most of what we deal with in life is uncertainty.

We just don't know the probabilities. We don't know what can happen. And the best thing to do there is to just build up that buffer, that lost capacity, that protection, and then don't spend so much time worrying about all the things that could happen. We can focus on the present. We can focus on building our human capital, our income, our knowledge of asset class. So we can take walks. We

We can meditate and not get into a loop of fear of all the things that could happen. There's an endless list of things that can happen.

In fact, that's one definition of risk. More things can happen than actually will happen. Very wide range of potentialities. So instead of listing out all the things that could happen, better to focus on building up our reserves, our buffer of assets and skills and knowledge, and just focus on the present, things that we can control.

and then be willing to take some risk, but in very specific areas with assets that we're willing to suffer losses with. And we can learn from those losses, and we can also learn from the gains. And that's another way just we become better investors, but actually investing in more risky projects. That's some thoughts on how to become a better risk taker. Thanks for listening.

I have enjoyed teaching about investing on this podcast for over eight years now, but I also love to write. There's a benefit to writing over podcasting, and that's why I write a weekly email newsletter called The Insider's Guide.

In that newsletter, I can share charts, graphs, and other materials that can help you better understand investing. It's some of the best writing I do each week. I spend a couple of hours on that newsletter each week trying to make it helpful to you. If you're not on that list, please subscribe. Go to moneyfortherestofus.com to subscribe to the free Insider's Guide weekly newsletter.

Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation, your specific loss aversion or loss capacity. This is simply general education on money, investing and the economy. Have a great week.