How do you think about investments and risks? For many people, the way we think about risk in specific situations is affected by our perceptions of how good or bad things are overall — and how that might change in the future.
For example, just watching or reading the news can give rise to fears about financial security, especially when the world seems volatile. You might ask yourself: Do I have enough money saved up? Is it invested wisely? Can I meet my goals and avoid financial disaster?
On the other hand, experiencing something hopeful and positive can shade your outlook as it relates to your finances. You might feel that your investments are doing well, and that your dreams of a peaceful retirement are just around the corner.
The list can go on and on, and sometimes making decisions about these questions is tough. At the heart of those decisions is the issue of risk: how much risk you’re facing, how to measure it, and how to manage it.
In investing circles, “risk” is usually something measurable. One common approach is the use of standard deviation, which is how much the returns for a specific security like a mutual fund or stock may differ from the average return.
While the concept of standard deviation is data-based and informative, you might not be using it for yourself. Many investors use another approach: risk perception, or how risky something appears to be. Risk perception isn’t always based on data or information. In fact, sometimes it is based on emotions or outright cognitive biases.
Sometimes, we perceive more risk than there actually is.
For example, after the Fukushima nuclear power plant disaster in Japan in 2011, there was widespread concern about radiation exposure. American pharmacies saw a run on potassium iodide, which was reported to help prevent radiation-induced thyroid cancer, despite the fact that there was no evidence of higher radiation exposure in the United States.
In other cases, we worry less than the math tells us we should. Consider the many stories of day-traders or crypto-currency enthusiasts losing tens of thousands (or more) on their bets, sometimes within the span of a few weeks or months. To those traders, the losing bets probably appeared reasonable and worthy of optimism.
The trouble with risk perception is that it drives a lot of our decisions, but it isn’t always accurate. Sometimes, it’s disastrously inaccurate. As a result, relying on risk perception alone can be problematic when it comes to investing for the future.
You can improve your relationship with investment risk by bypassing perception and going straight to the math.
Talk to an appropriate professional who understands the specific risk factors of a particular investment strategy, and what those factors mean in terms of dollars and cents. Work together to find an approach that keeps your risk exposure at an acceptable level for your financial objectives and needs. By walking through the numbers, you’ll be able to re-align your perception of risk with reality — and avoid betting the farm on an idea that was too good to be true.
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