Risk Does Not Fully Address The Feeling Of Loss

When assessing risk profiles, we need ask one more question. Is risk tolerance/avoidance, the same thing as loss tolerance?

Risk is theoretical

In theory it would be foolish to turn down a bet where the risk is $100 and the reward $150 if the odds on the outcome are 50-50. On average, the pexpected value of each bet is $50.00. That would certainly be true if there is a long series of bets. Eventually the profit would end up at $50 per bet.

That assumes you could sustain a lengthy series of losing bets. At 50-50, the probability of 10 straight losses is small but not zero. If you started with $3,000 you would be okay except in the case of losing the first 30 bets. A one in a billion possibility.

Loss is more fundamental

People deal with loss differently. The conventional wisdom is a loss of $1 hurts as much as a win of $2 brings joy. The numbers don’t matter because we are all loss averse while professing to have risk tolerance. Part of that relates to the baseline we address. If I have $100 and you offer me the bet above, I know the outcome will be one of, I have $250 or, I have $0. Zero dollars compared to the $100 I have looks big. $250 to the $100 is nice but not terrific. You might not participate.

If I offered you a bet with baseline zero, you would always participate. fifty/fifty chance I give you nothing or $50. Everyone would play. $50 gain compared to zero is huge.

Bigger numbers.

Suppose you are 65 and have $2,000,000 and that is ample to meet your needs. I offer you a bet with 50-50 odds that will pay you $3,000,000 or cost you your $2,000,000. Will you play now? Almost certianly not. Risk and expected value are secondary to potential loss.

Buffett wisdom

Buffett seems to address loss and deal with risk as a separate issue. Consider his observation on Long Term Capital Management founders.

“To make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish.

In a more recent discussion he considers his price to play Russian Roulette with a gun with one bullet and a million chambers. His answer, there is no price at which he would play. The reasoning follows from the LTCM idea. Risk losing something you need for something you don’t need is a bad bet at any price.

The moral

  1. Don’t risk what you need for something you don’t
  2. Always ask “How much can I lose?” before “How much can I make?
  3. Understand baseline references.
  4. Be sure you address the idea of loss with clients in the discussion of risk.
  5. Loss has more emotional meaning than risk.
  6. Remember an observation that explains much client behaviour. “There is such a thing as a paper profit, but all losses feel real.”

I help business owners, and professionals understand and manage risk and other financial issues. To help them achieve their goals, I use tax efficiencies and design advantages to acquire more efficient income and larger, more liquid estates.

Please be in touch if I can help you. don@moneyfyi.com 705-927-4770

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