Risk Preferences

Aug 2, 2022

Risk Preferences

Before making any investment decisions, it is critical to determine risk preferences.

You have probably heard the popular idiom: "the greater the risk, the greater the reward." This concept is part of an acclaimed financial theory coined the risk-reward concept.

The idea behind the risk-reward tradeoff - the more an investor holds onto a high-risk asset the higher the potential return.

There are two key caveats here -

This is a potential reward, not a sure thing, which means that there is an inherent risk in this scenario. “All or nothing” might come to mind because this too is a potential outcome.
Not every investor has an appetite for high-risk frameworks. Risk-averse investors also make for savvy investors, especially in the long term. Think of Aesop's timeless fable “slow and steady wins the race.”

The bottom line is that investors should determine their risk preferences before they begin investing.

Investors need to be able to withstand the ramifications of said risk. A mismatch between their risk level and portfolio investments can completely disrupt their financial plan.

For example -

An investor with low-risk tolerance invests in the high-risk asset, Bitcoin (BTC), in November 2021 at $67,582/share. The same investor reaches July 2022 and is concerned about BTC price, presently trading at $21,464. If the investor chooses to liquidate their position, their return on investment would be -68.25%, representing a loss of $46,123 per share.
Why might they do this?
Perhaps they believe that BTC will continue to plummet further, extending their loss, or they want to buy a car and need to liquidate to make the car purchase. Regardless, the investor sells their position in July 2022. According to the numbers above, BTC was an unprofitable investment decision for this individual. It turns out that this particular investor required a lower-risk asset as they are either risk-averse or have a less flexible and shorter investing horizon.

Investors should consider their investing horizon (how long can they hold their position in the face of market volatility) based on their investment goals and financial reality.

Stocks and crypto assets are considered high-risk investments. There is a clear consensus in this regard within the investing community. While stocks have the highest average rate of return among financial products there is never a guarantee of profit.

Real estate, on the other hand, is considered by investors one of the most low-risk investments. Investor sentiment could also contend that real estate is subject to more risk than the bonds and money market, consequently requiring a thorough cost-benefit analysis.

The Takeaway -

A diversified and thoughtfully managed real estate portfolio can be low risk. And comparatively, real estate and housing, in particular, are considered lower risk relative to equities or crypto asset heavy portfolios.

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