Investing

How much risk will I tolerate?

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Recently, while reading Lifecycle Investing by Ian Ayres and Barry Nalebuff, I wondered how to calculate my relative risk aversion(RRA). Financial advisors often ask their clients a series of questions to calculate their risk and determine the suitability of different types of investments. These questionnaires are challenged because many people often say one thing but do something completely different in reality. In other words, they lie.

I decided to examine myself by taking one of these questionnaires. If you wanted to repeat my process for yourself, here’s the one I used. I found a few of the questions interesting and thought provoking. By sharing my answers, I’ll be opening up my possibly irrational behavior for your enjoyment. I’m hoping you’ll tell me where I’m wrong and, more importantly, why 🙂

Question 1: You’ve got to know when to hold ’em

In general, how would your best friend describe you as a risk taker? 

It’s likely not a secret that I love researching and analyzing. My research invariably has gaps or leaps of logic, and I do a fair bit of it. My best friend would probably describe me as “willing to take risk after completing adequate research.” I’m anything but a gambler and a thrill seeker, and if the analysis makes sense, I’ll dive right in.

Question 2: The Price Is Right!

You are on a TV game show and can choose one of the following. Which would you take?

  1. $1,000 in cash
  2. A 50% chance at winning $5,000
  3. A 25% chance at winning $10,000
  4. A 5% chance at winning $100,000

B and C seem equivalent to each other. Both have an average payout of $2,500. A game show is probably a one-time event (unless you’re someone like Ken Jennings), but throughout my life I’ll likely be faced with many similar-sized gambles, even if they aren’t dressed up as TV game show winnings. Realizing that, I’m better off taking as many of those bets as possible, and on average I’ll come out ahead of A. I’d go with B because C has the same average payout and seems to me like unnecessary asymmetry in returns. I’m probably missing something here.

Why not choose D with its larger, average $5,000 payout? I don’t know if I’ll face twenty bets sized like this over the course of my life. Maybe? Probably? On the other hand, for me, going through nineteen stressful losses would likely outweigh that single (on average) win.

Question 3: Losing My Job Before A “Once-in-a-Lifetime” Vacation

You have just finished saving for a “once-in-a-lifetime” vacation. Three weeks before you plan to leave, you lose your job. You would: 

  1. Cancel the vacation
  2. Take a much more modest vacation
  3. Go as scheduled, reasoning that you need the time to prepare for a job search
  4. Extend your vacation, because this might be your last chance to go first-class 

In many respects, our trip to Spain in the Fall of 2019 was a once-in-a-lifetime vacation. If I had lost my job just prior, we would have still gone, knowing that it would have made it more challenging to relax during it. By three weeks before the trip, we had already purchased airline tickets and made our Airbnb reservations. The remaining expense was basically groceries and a few train tickets between cities. 

What if we hadn’t already incurred most of the expense already? It would have been much harder to justify. If it was truly once-in-a-lifetime–and with my oldest getting ready to leave for college the following year, it was!–I’d probably still go, maybe scaling it back a bit, and maybe going not quite as long.

Question 4: Investing “Found” Money

If you unexpectedly received $20,000 to invest, what would you do? 

  1. Deposit it in a bank account, money market account, or an insured CD
  2. Invest it in safe high quality bonds or bond mutual funds
  3. Invest it in stocks or stock mutual funds

We already save and invest a significant portion of our regular income. And in the past, when we’ve seen windfalls, we’ve typically just rolled it into our investments.

This question seems to suffer from having a specific dollar amount that could be more a function of your current wealth. For some, $20k is a huge number, but for others, not so much. Maybe making it a percentage of income or some relative number would help?

I suspect my answer will likely differ when I’m on the cusp of retirement, having exhausted most of my human capital.

Question 7: Investing With Leverage

Some experts are predicting prices of assets such as gold, jewels, collectibles, and real estate (hard assets) to increase in value; bond prices may fall, however, experts tend to agree that government bonds are relatively safe. Most of your investment assets are now in high interest government bonds. What would you do? 

  1. Hold the bonds
  2. Sell the bonds, put half the proceeds into money market accounts, and the other half into hard assets
  3. Sell the bonds and put the total proceeds into hard assets
  4. Sell the bonds, put all the money into hard assets, and borrow additional money to buy more 

Okay, only answer D involved leverage. The rest are more about how I feel about bonds. I think my recent decision to dump my bond holdings makes my choice of C obvious. I did hang out in bonds far longer than I probably should have. I doubt I would have ever chosen A. I’m not quite ready to take on leverage to get deeper into the market (not paying off my mortgage, notwithstanding), although Ayers and Nalebuff have me wondering about it.

Question 8: Gains Versus Losses

Given the best and worst case returns of the four investment choices below, which would you prefer? 

  1. $200 gain best case; $0 gain/loss worst case
  2. $800 gain best case; $200 loss worst case
  3. $2,600 gain best case; $800 loss worst case
  4. $4,800 gain best case; $2,400 loss worst case 

It’s hard to answer this one without an assumption that the odds are 50/50 between the best and worst cases. With that assumption, D is probably the answer that makes the most sense. 

So why did I choose C? While the average gain in scenario D is still larger, D’s worst case scenario is three times that of C while it’s gain is only 1.8x better. To me, that feels like a worse deal in terms of the downside volatility. I’m sure I’m being irrational here.

Questions 9 and 10: Do Losses Hurt More than Gains?

In addition to whatever you own, you have been given $1,000. You are now asked to choose between: 

  1. A sure gain of $500
  2. A 50% chance to gain $1,000 and a 50% chance to gain nothing 

In addition to whatever you own, you have been given $2,000. You are now asked to choose between: 

  1. A sure loss of $500
  2. A 50% chance to lose $1,000 and a 50% chance to lose nothing 

In both questions, the average outcome for all answers is $1,500. I’ll gladly accept that it’s irrational to choose a sure win while only wanting a chance at a loss.

Question 11: Are Commodities For Me?

Suppose a relative left you an inheritance of $100,000, stipulating in the will that you invest ALL the money in ONE of the following choices. Which one would you select? 

  1. A savings account or money market mutual fund
  2. A mutual fund that owns stocks and bonds
  3. A portfolio of 15 common stocks
  4. Commodities like gold, silver, and oil 

There’s a lot of assumptions you have to make here. How long do I have to stay in these investments? Do I get to choose the common stocks? If so, I would choose the top 15 holdings in the S&P 500 and call it a day.

Question 13: How Do I Feel About Crypto?

Your trusted friend and neighbor, an experienced [techie], is [investing in an ICO]. The [ICO] could pay back 50 to 100 times the investment if successful. If the [ICO] is a bust, the entire investment is worthless. Your friend estimates the chance of success is only 20%. If you had the money, how much would you invest? 

  1. Nothing
  2. One month’s salary
  3. Three month’s salary
  4. Six month’s salary 

Yeah, so I took some liberties here. The original question was about a gold mine, and frankly that felt dated to me. If it was a gold mine, I might have chosen B. Leveraging a month’s wages (which isn’t a huge deal) into 7 to 14 years of income (on average) is appealing. And while the math isn’t identical, I’ve faced similar situations when deciding whether to exercise option grants or not. Faced with enough of these gamble, and a true 20% chance of success, it makes sense to take that bet.

An ICO? Not a chance. Way too many hucksters and charlatans in crypto.

Conclusion

The questionnaire lower bound is 13 and the highest score possible is 47. My overall score was 36, putting me in the “High risk tolerance (i.e., aggressive investor)” category. Honestly, that was higher than I expected.

Did taking this survey make me rethink any of my investments? Nope. Still in low cost index funds with some dabbling in selling covered calls. 

What is your appetite for risk? Do you have a favorite risk questionnaire? What irrational behavior do you see me making here? I’d love to hear about it in the comments.

Hasta luego!

2 thoughts on “How much risk will I tolerate?

  1. Fun quiz. Some that standout for me:

    Q2: D for me. Expected value is $5k. I’ll gamble $1k with those odds. But I think the decision is partly based on how much and extra $1k will impact your life. For me, an extra $1k won’t do much but $100k will so I’m taking the best expected value bet.

    Q8: B for me. Assuming equal odds for best case and worst case happening, the expected outcome of B is best. I’ll look for lots of B situations vs taking case C or D to make the same money at less risk. If it’s a one shot deal, then I’d probably go with C too.

    Q9/10. At even money, I’ll take certainty. Why stress over something unless you have a edge.

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