Risk And Risk Aversion
You are somewhere on the continuum between being a risk taker and being risk averse. Risk aversion is a measure of your preference for uncertainly over certainty. If you are too risk averse and conservative, you limit your ability to make decisions and therefore your ability to succeed. In my experience most people are somewhat risk averse. I have also noticed that those who take controlled risks in career, business and investments are generally the most successful.
For example, a risk averse person might prefer to stay in a low paid job than move jobs, or start their own business; even when such a change is likely to bring about increases in income, job satisfaction, status and so on.
Many people make choices based on the worst possible scenario rather than the likely probability of negative things happening. When I have a decision to make, it often helps me to imagine the worst possible scenario but I also:
1. Put that possibility into perspective; and
2. Make plans to ensure the worst possible scenario does not occur.
So for example if I decide to set up a new business the worst case scenario might be:
• It fails and I feel a bit embarrassed;
• I lose the time I spent trying to make it work;
• I lose a pre-defined amount of money;
• I have the opportunity cost of not doing something else with my time and money.I can live with all of these consequences, so if I see a significant upside opportunity I am happy to set up a new business.
It might be useful for you to think about how risk averse you are. In the final chapter of this book, I note that one of the main regrets at the end of people’s lives is they did not take a leap of faith or an opportunity when it was presented to them. If you are too risk averse this is a significant possibility.
There is a financial type of risk aversion called dollar fear. This is when the pain of losing $1 is greater than the pleasure of making $1. This fear often paralyses people when it comes to investments. They would rather put $20,000 in the bank at 3% interest than invest the money in a rental property. Over a long time, money in property increases in value faster than money in the bank, but some people fear the possibility of losing any of the money. Similarly, some people will not risk $2,000 to start a business even though the upside (money they could make) is hundreds of times more than the downside ($2,000).
One way to successfully control financial risk is to always protect the downside. It is far easier (and more profitable in the long run) if in any financial decision you protect or limit any losses. Let’s say you have $5,000 to your name. If you set aside $3,000 to start a new business, that is all you can lose. Providing you do not sign any personal guarantees on loans or leases etc, and providing you limit your spending to $3,000 you cannot lose any more. Yet your business might be earning you $100,000 a year in two years time. It helps to concentrate on the potential upside and allow yourself to risk the funds you have put aside.
If you are very risk averse and this is affecting your decision-making, start small and get some confidence by taking small risks. Alternatively change your mind set by concentrating on what you are missing out on by not taking a controlled risk.
Of course risk aversion is not confined to business and finance. We all have risk thresholds for relationships, career, adventure, extreme sports, vacations, overseas travel, selling ourselves, asking others for their time and so on.
The important thing is to evaluate where your risk thresholds are and to think about whether your current risk thresholds are causing you to limit your opportunities, outcomes and experiences. If you recognize you are being held back by risk aversion I recommend taking small but deliberate steps to push out the boundaries a little bit at a time.
Also as we have discussed previously, use leverage to get yourself to take controlled risks. Imagine yourself in a rut doing the same thing over and over for years at a time. Imagine yourself in your rocking chair at 85 years old looking back in disappointment at the missed opportunities.
As you take small steps of controlled risk, you will find it gets easier and easier. You will find that any negative consequences are not nearly as bad as you had imagined. You will also find that you feel more alive, more excited and more stimulated. You will also be more interesting to other people. This of course all builds on itself as a virtuous circle until you are doing what you want to do without fear.