Risk and reward
Lately the subject of “risk” has been on my mind a lot, as well as on the minds of my friends and clients, so I thought I would jot down a few notes on the subject.
In general most investors focus equally on risk and reward; how much am I going to make and how much could I lose? Those two questions are capable of generating a ton of emotional response. That emotional response can make investing very tough.
If you think about reward for example, it makes you feel happy! One looks at the amount of money that could be made off the investment and all the things that could be done with this money – buying a new house, a new car, college for the kids, an awesome vacation, a donation to ones favorite charity, the list goes on and on. The emotions that go with this, exhilaration, enthusiasm, and joy are all very desirable emotions. They also are very much aligned with man’s impulse to survive well. So, making more money is a great thing and the contemplation of it can get one very motivated to do things that lead to the second part of the equation… take a risk!
Risk, seems to live at the opposite end of the spectrum of emotion.. When one starts to think about losing money, losing it all, not being able to pay your bills, not having money to retire, etc. one can get struck hard with some pretty volatile emotions. Fear, grief, apathy, and all sorts of things come up at the thought of somehow losing one’s basis for survival, “money”. Without money we think that the game is basically over. Well, truth be told, money is really not the basis for survival; it is your skill and persistence in life that guarantees your survival, but that is the subject of a different Blog.
So now we see the stark contrast of emotions that live at the two ends of this equation, Risk and Reward. It is no wonder that investors find it very hard to pull the trigger and make an investment when there is so much emotion at play. It actually creates a “midway” scenario that normally results in the conclusion to “do nothing”.
Which when you look at it makes sense. Usually one bounces back and forth, back and forth, until something tips the scale – enough reward to want to go for it, or enough due diligence and information to take out enough of the potential risk to go for it; or, enough information to decide there is too much risk and not make the investment. There are several possible outcomes but I think you get the idea.
I point all this out to hopefully help you understand the dynamics of what is going on when you approach an investment. I actually go through these emotions myself when evaluating an investment, and I have been investing for many years. But, because I have trained myself to understand all of the pieces of the puzzle related to investing and how the emotions interact with my due diligence I am able to control the process and not be paralyzed by it. Because the end goal is to give a yes or a no, not a maybe…though I have sat at “maybe” from time to time.
Usually, a maybe indicates an inability to determine some parameters in the investment.
I personally feel that when one hits a maybe, the answer should always be NO. This is because, if you are squarely on a “maybe”, the only way off is to jump off the cliff, make the investment and hope. I would prefer to jump to safety, even if I am wrong, than to come back a year later and say to myself, “I knew something was weird with that investment”. The analytical mind is a very powerful tool and if it cannot compute something there is usually incorrect input or false information. Having false information regarding investing is equal to being on the front line of the old civil war army, you know you are the first one going to be shot.
So, a few tips to help with this process:
1. Determine what the actual risk is in the investment, if you can’t, don’t invest. Run the worst case scenario, five different ways at least. Because anyone who tells you there is no risk, is simply wrong. And, if you are not willing to experience the downside, don’t invest.
2. Determine the potential reward, and then figure out if there is any way you might not achieve what is promised or what you think you should get. And determine if you would be happy with the lower reward if the best case does not happen.
3. Understand your own emotional responses to the risks and rewards, and move them to the side in doing your analysis.
4. Learn to do your own due diligence or hire/work with someone who does know how to do it. By the way it is a definite skill, not everyone can do the correct evaluation. In fact it is a common error; a business person thinks because they ran a successful business or because they are smart they can evaluate another business. There is an exact technology for evaluating and analyzing companies.
5. Portion out your assets for different asset classes by risk and reward. I have some VERY low risk, some medium, some high, some currency, some hard assets, and each one carries with it a certain set of parameters in regards risk and reward. It is important not to kid yourself, because in a tough time all things can correlate and you find you do not have real diversification. But, it can be done, simply by thinking about how different investments respond in different environments.
6. Realize that investing is a skill, not a hobby. And you must treat it in a professional way or risk the wrath of poor choices. When I thought about learning to fly I knew if I could not treat it as a professional activity I should not do it, because if I screwed up it could kill me!Well, investing is not that bad but it can sure seem like it … a few guys jumped out the window in the great depression.
7. And finally, keep producing money, keep creating new money, produce something. It will make you feel better than sitting around watching your money and telling it to “Work Harder” for you
I wish you luck!
As I am just getting started with blogging, I hope you find this informational in some way. I would appreciate any feedback on my blogs.