How To Find Out Your Risk Attitude
It is important to know what your risk attitude is, as it can determine what kind of investment options are good for you.
What does risk attitude mean
People love putting people in boxes based various qualities, attributes, and anything really. We have a biological need to belong into groups for comfort and protection.
I suppose that’s why all these different quizzes to see which “insert topic” you are exist.
Our willingness to take on risk is no different. In fact, research has shown that people can split into three different groups based on their attitudes towards risk taking.
These are risk avoidance, risk aversion and risk seeking.
What you invest in should depend on how you feel about risk, or in other words, what your attitude towards risk is.
This is because if you are invested in something that is riskier than you feel comfortable with you might constantly feel anxiety over it and maybe sell your investments in dip realising your losses.
On the other hand if you are invested in a too conservative manner (only in term deposits for example), even though you were comfortable with more risk, you would be missing out on better returns.
The three different risk attitudes
Risk avoidance is pretty self-explanatory; you are unwilling to take on risk, even if there was a reward for it.
Risk aversion and risk seeking might cause confusion though.
In this context, risk seeking behavior could be compared to gambling.
Risk seeking person enjoys and seeks the thrill of the risk itself, and it could often be out of proportion with the chances of getting a possible reward.
Risk aversion on the other hand describes behavior where an investor is only willing to take on more risk if they are adequately compensated for it.
While most investors are risk averse, this doesn’t mean that everybody is willing to take on the same amount of risk.
The amount of risk you’re willing to take on is known as risk appetite, which depends on your personality, and theoretically on your time horizon.
An example of risk aversion in action
Anyway, when I say adequately compensated, I mean that a risk averse investor will take on more risk if there is a possibility of a higher return.
For example, if you were to look into buying a bond (bonds are a way for an investor to become a lender to a government or a company) and you had two viable options:
First bond was with the New Zealand government, let’s say for 5 years.
(This means that you will be paid interest for 5 years and at the end of the 5th year the government will pay back the principle.)
Second bond option is with Air New Zealand, for 5 years as well.
Now which do you think is more likely to not pay you all the interest and/or the principle at the end of 5 years?
Air New Zealand would be the right answer.
(Although I have to say that Air New Zealand is a pretty solid company, I just mean that compared to the New Zealand government their theoretical risk is higher.)
So, a bond investor would expect Air New Zealand to pay higher interest than the New Zealand government to compensate for the extra risk they are taking by lending Air New Zealand money.
What is your risk attitude like
Like I mentioned earlier, most people are risk averse.
They are willing to take on more risk, if the return rises with the risk. The degree of how much anyone is comfortable fit then depends on a few more factors.
But you might be risk avoiding if the thought of sharemarket volatility makes you sick to your stomach.
Or maybe you are risk seeking if you are the first to jump on a new trendy investment with no clear idea whether the payout from the investment will match the risk you are taking on.
Maybe you also enjoy gambling and treat investing as an extension of it.
At the end of the day, these two extremes are not good for your financial health.
In the other end of the spectrum you are missing out of your money growing (in fact your money is likely to lose value due to inflation), in the other end you might be gambling your money away.
And that is no longer term strategy, unless maybe if you are Gladstone Gander.
Depending on the person, financial education might help get these extreme people towards financially healthy risk averse behaviour.
In very bad cases, therapy might be beneficial in order to get to the root of the behaviour.
A new emerging field in mental health is financial therapy, or financial counselling.
The idea of it is to equip financial advisors with the tools to help their clients with the behavioural and emotional aspects of money.
Financial therapy could be a great tool if someone has suffered from financial trauma, or in general has hard time understanding their behaviour when it comes to money.
What is your risk attitude? I’d love to hear in the comments!
