Weekly Puzzle #4: How risk averse are you?
The Set up
Both economics and finance are built on the pillar of risk aversion, i.e., that investors need to be paid extra (over and above an expected value) to take risks. That notion of risk aversion has been challenged and modified over time, but it still is at the heart of how we measure risk and come up with expected returns. Economists agree that not only does risk aversion vary across individuals but it also varies, for the same individual, across time. In this puzzle, which has no right answer, I would like you to wrestle with the question of how risk averse you, explanations that you can offer for that risk aversion and the consequences for your business and investment decision making.
Measuring Risk Aversion
One of the side products of the growth of robo advisors is a proliferation of tools that investors can use to assess how risk averse they are. This article in the New York Times nicely sets the table. It is an old article and the free risk aversion measurement links don't work but you can find other tests of risk averson online. Here are a couple more, if you are interested:
- NJAES: https://njaes.rutgers.edu/money/assessment-tools/investment-risk-tolerance-quiz.pdf
- University of Georgia: https://pfp.missouri.edu/research/investment-risk-tolerance-assessment/
Take the tests, both to get a measure of how risk aversion gets measured and how risk averse you are as an individual.
Explaining your risk aversion
Once you get your risk aversion measure, you have some explaining to do. In other words, your risk aversion is a function of lots of different things including
- Where you grew up: Those who grew up in volatile, emerging economies tend to be more risk averse than those who grew up in stable, mature economies.
- How much money you have: The more of a safety buffer you have, the less risk averse you tend to be.
- Your parents and their risk aversion: Risk averse parents can either make you very risk averse or sway you in the other direction (if you are prone to rebel).
- How well off (or not) you were, during your growing years: The better off you were in your growing years, the less risk averse you tend to be.
- How old you are and whether you are male or female: Younger people are more risk averse than older ones, and females tend to be more risk averse than males.
- You (what you were born with): The X factor!
See if you can find a link between your risk aversion and your characteristics.
The Consequences of your risk aversion
Now consider the consequences of your risk aversion measure. In particular, think about how it will affect your
- Asset allocation decisions: Your risk aversion will affect how much money you hold as liquid, riskless investments (checking accounts, money market funds) as a percent of your overall portfolio. Even if you don't have savings yet, think about your future asset allocation judgments.
- Asset Selection: Your risk aversion may affect what stocks, funds or other risky assets you hold in your portfolio.
- Borrowing: Your risk aversion will also determine whether you borrow money to invest and if you do, how much.
- The equity risk premium, i.e., what you can earn on stocks over and above the T.Bond rate, right now is about 4.75%. Given your risk aversion, do you feel this premium is sufficient given how risky you think equity is as an investment? (I know that this is subjective but make your best choice)
- Do you think that your risk aversion is affected by what you read and watch? If no, why not? If yes, how?
- If the market goes up strongly for the rest of the year, do your think your risk aversion will change? If so, in which direction?
- If the market goes down significantly for the rest of the year, do your think your risk aversion will change? If so, in which direction?