What is Risk Aversion?

2 facts about risks:

1️⃣ Risk measures the probability of an event happening and not how often it actually happens.

2️⃣ Humans generally frame risk as how often a bad thing happens, BUT risk is all about probability, so risk can measure how often something good happens like winning the lottery after risking your $2 to make the bet.

“Risk aversion refers to the tendency of an economic agent to strictly prefer certainty to uncertainty.” – Corporate Finance Institute

Risk is often expressed in the form of a ratio “1 in 10 chance”. So in the context of a raggedy bridge that could fall down, the risk of it falling down would essentially be a ratio that states 1 out of every 10 people who crosses the bridge will trigger a collapse. A 1 in 10 chance of a bridge falling is a bigger risk than if it were a 1 in 100 chance.

Obviously you want to take bigger risk when the odds are in your favor (a 1 in 10 chance of winning the lottery). If the odds are not in your favor (walking across an old bridge) you probably want to take a smaller risk which would lower your chances of falling to a 1 in 100 chance.

As mentioned before, risk doesn’t measure how often something happens, so that bridge could fall on your first try even with 1-10 odds, and you could play the lottery millions of times at 100-1 odds and still lose every time.

The trick is realizing that every time that you play the odds (probability) reset, I learned this playing roulette. There is no such thing as a hot number, if the odds are truly random even if your number comes out 10 times in a row, on the next spin the odds always reset.

What does this have to do with stock?

let’s get to stock, in the stock market people mistakenly believe stocks have momentum but their logical bias prevents them from applying the concept evenly. People think bad stocks will go down forever and they believe good stocks will eventually lose momentum and fall.

This behavior causes investors to limit their downside risk by not investing in falling stocks, BUT it also prevents investors from buying stocks that are rising in value.

It’s perfectly natural to protect yourself from down side risk by not investing in a falling or being hesitant to invest in a stock that has done so well that it may be over priced.

It’s important to know that when you hesitated to invest in that stock that was rising, you created upside risks. Yes you reduced your chances of losing money, but you also increased your risk of not participating in any future gains that the stock has made.

I have done this with a $5 stock, it shot to $10 and I thought it was too expensive to buy because what if it falls back to $10? The stock went to $20 and I missed another chance to double my money.
So what do you do?

If you are going to buy the stock you protect yourself by DCA’ing (dollar cost averaging) the stock or usei-me limit orders.
Dollar cost averaging is where you repetitively buy the same amount of stock on a schedule regardless of if it’s up or down.

A DCA strategy protects you because your constant investments create a situation where you theoretically get the best average price and since you’re always buying, you protect yourself from both upside and downside risk.

Limit orders allow you to buy the stock now, then you’d set an automatic sell order if the price falls below a specific preset number. You can cancel the order any time, but this allows you to participate in the upside price gains but protect your from losing any money (stop loss) if you set the sell price slightly above your purchase price.

Leave a Reply