Perceived vs. actual risk tolerance

[Evan]

I'm not sure if this is going to warrant a lot of of discussion but I was just thinking about it while I was reading this forum.


I think most people's perception of their risk tolerance is higher than their actual risk tolerance. A lot of times when people come to this forum asking for investment advice I read something like "I'm a poker player/young so I'm willing to take a lot of risk." I don't have a ton of experience dealing with people's psychology in this area, but the little I have along with my own thoughts on the subject make me think what they really mean is "I'm a poker player/young [and have probably run hot so far in life] and I want to make a ton of money/don't really understand the risk I'm talking about." I think it kind of goes along the same line of reasoning as this article in Time. I wish I could expand a little more on why I think this, and maybe once I have some more time to think about it and read other people's posts I will formulate some more concise ideas.

Do you agree? Always or maybe just for a certain demographic? I am definitely overexposed to younger people so my thoughts are likely skewed in that direction.
Do you think this is common knowledge?
What implications does/should this have for us as investors? (Is there a way we can use this knowledge to our financial benefit?)

[Thremp]

When we talk about risk in investing, aren't we talking about variance more so than risk of ruin? I think this question is just as important if not more.

[Evan]

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When we talk about risk in investing, aren't we talking about variance more so than risk of ruin? I think this question is just as important if not more.

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I don't think that questions important at all. They're both functions of the same phenomenon; more accurately, I suppose, risk of ruin is a function of variance. I don't think a lot of people are going to actually go broke by investing in stocks because of the distribution (it's extremely rare for a stock to become worthless), so I guess we can say we're talking about variance. How would your answer change if we were talking about risk of ruin?

Could you maybe be a little clearer about what you mean?

[SlowHabit]

"They all got a plan -- until they get hit." -- Mike Tyson

[gull]

Actually, you've got it backward. Most people can tolerate way more risk than they think (ESPECIALLY when invested for long periods of time).

http://hec.osu.edu/people/shanna/chen.pdf

[Thremp]

Evan,


Your risk of ruin with the stock market is almost non-existent. Think of it in poker terms... You wanna run at 4PTBB/100 with a 50BB/100 SD or you wanna run at 4.5PTBB/100 with a 95BB/100?

I think people equate stock market risk with risk of ruin when its actually better to use variance to describe whats going on.

gull,

I agree. With most people who say "I am buying a house in 5 years, I want to invest 10k toward the down payment." They don't need this money. They can pop it into emerging markets and wait a little longer to get a house or what not with situation like that.

[chiachu]

This is an interesting topic for me, since i am planning on investing in a Roth IRA as soon as i get my first real paycheck in about a month.

[ QUOTE ]
With most people who say "I am buying a house in 5 years, I want to invest 10k toward the down payment." They don't need this money. They can pop it into emerging markets and wait a little longer to get a house or what not with situation like that.

[/ QUOTE ]

"I want to buy a house in 5 years" is pretty much what i was thinking (except i was planning on starting with 4k, and depositing the max into the IRA every year). Are you saying it would be better to put it into a high risk fund? This was kind of my plan, since i figure it would be tough to go broke in the stock market... and even if i do end up losing over 5 years, not buying a house immediately after 5 years isnt a huge deal.

I dont mean to change the topic, but a question i had about Roth IRA's: I read that for mutual funds you can invest up until April of the next year (and still have it count as a part of the previous year). Does this apply for IRAs as well? Can i invest 4k in say Feburary and say its for 2006, then invest another 4k in May and say that is for 2007? Also, since it has to be "earned income", does the money have to go directly from my paycheck to IRA account?

[Evan]

gull, looks interesting. I'll read it later.



Thremp, I don't know why you're continuing to talk about risk of ruin versus variance. First, they're the same thing. Second, I said the same thing you did regarding the probability of actually going broke in the stock market. I also don't know what you're trying to say with your poker example. I might prefer a lower expectation with a lower standard deviation for a number of reasons; it might result in a bankroll requirement decrease such that I could move to a higher level sooner and make more money.

I also have no idea what you mean by, "I think people equate stock market risk with risk of ruin when its actually better to use variance to describe whats going on." Do you think people are assigning nominal values of risk of ruin that they're willing to accept and applying that to standard deviation? For example, is someone sitting around saying, "I'm willing to accept 3 units of standard deviation" when they mean "I'm willing to accept 3 units of RoR"? That's about the only think I can fathom that you might mean, despite the fact that it's laughably absurd.

Last thing, your comment about people investing money for a house not needing that money doesn't really mean much. I could just as easily say "They absolutely need that money and preservation of capital is the highest priority." We've both made baseless claims. What do you mean they can wait "a little longer"? A little longer, in terms of a volatile financial market, can be many many years.



chiachu, sorry dude but, "I dont mean to change the topic," was obviously a lie.

[Thremp]

Evan,

I have class in a bit so I'll try to expand on this somewhat later. As you said yourself, your risk of ruin in the stock market is almost non-existent. I think people are looking at the problem in the wrong way instead of like in the poker example I presented (also in your response to that, try not to break the structure of thought problems when answering it kinda ruins the point of them).

Lastly, I think we can both agree there are many different types of investing that will help achieve various goals. No one here is going to recommend a radical retirement outlook for anyone. I'm sure everyone here recommends dollar cost averaging into a mixed portfolio of US and foreign equities at our age. However, most of the people posting are basically saying "I have five figures of discretionary income. I'll gladly take 1.2:1 flippaments all day since I just wanna get rich."

[turnipmonster]

I see optimism bias in myself and others all the time, I think it's especially prevalent in the subculture of successful poker players. that's a good article in TIME, I didn't realize they had good articles.