Understanding your risk tolerance

“Fortune favors the bold”–Virgil

Do you buy a new laptop for $1,000 or reconditioned one for $900? The reconditioned product is $100 cheaper, but presumably more likely to fail. Do the savings make it worth taking a chance? Situations like this, where decisions are made under uncertainty, warrant risk analysis.

The two questions in risk

Two questions are central to risk analysis. First, can you objectively measure the risk? I’ll focus on financial risk, which is defined as the spread, or mathematically, the variance of outcomes. The more dispersed likely outcomes are (the higher the variance) the more risk there is.

In the laptop example, the reconditioned product will probably behave more erratically than a new laptop, hence buying it is riskier. Why do you take on extra risk? Simple: the reconditioned product is cheaper. This is because in well-functioning financial markets, a riskier investment must provide a a higher potential return (i.e., a riskier product is priced cheaper than comparables with less risk).

The second question in risk analysis is: what is your own tolerance for risk? Economists consider three risk types:

  • Risk averse, meaning getting a sure $1 is better than entering a gamble that gives you $1 on average–which is naturally what most people are
  • Risk neutral, meaning getting a sure $1 is equal is equal to entering a gamble that gives you $1 on average–think of how the Terminator might view finances
  • Risk loving, meaning getting a sure $1 is worse than entering a gamble that gives you $1 on average–think of people playing the lottery or the slot machines

You can understand your financial risk by taking a large survey about risk. The survey may even surprise you. I discovered I could take on more risk than I thought.

Successful risk management

One more thing: successful risk management is about matching your risk tolerance with rewarding risky opportunities. Sounds easy enough, but we often fail to take risks for fear of looking stupid.

One study (pdf) encourages NFL coaches to be more aggressive on fourth downs and go for it instead of punting. While the study was praised, it has not been widely incorporated as a good strategy among the league. The book The Wisdom of Crowds offers one explanation: an individual coach who takes the new advice fears failure because the media can singularly blast him for acting different from the group. There is a safety to keeping to conventional wisdom, even if you know that it’s wrong.

Who knows, though, attitudes may change. Some organizations have differed from the group and been successful: see the New England Patriots.

Other articles on risk

I have written many articles about risk on this site. Here is a sampling of a few of my favorites:

–Why I would buy disability insurance: there is a great benefit to being protected from loss of income due to disability

–The misbehavior of markets: market risk is not priced well, claims Mandelbrot in this fascinating book. Mandelbrot says that markets follow a fractal pattern rather than a bell curve and explains how he would revise academic finance to price risk better

–Myth: young people need to invest aggressively: Young people should be safe with their money, in my opinion. When risks are carefully laid out, it is often the case that older people are in a better position to invest aggressively.

This post is part 4 of a 7-part series on the most important lessons in personal finance. Here are links to all of the articles in the series:

  1. Personal finance is not about money
  2. Know your preferences
  3. Consider opportunity costs
  4. Calculate risk
  5. Know the time value of money
  6. Consider taxes
  7. Know the value of your time


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  • Avnish

    While I fully understand the idea of risk tolerance, I think people might have problems adequately assessing just HOW risky a certain venture is.

    For instance, when talking about equities, the discussion becomes easier given the amount of pricing data that we have (i.e. all I have to do is take a chart, rip the numbers, find the variance within some time period, and base my decision on some numeric value). Heck, we can even use the VIX index to look at general market volatility and make a decision if we’re pressed for time.

    However, how does one practically determine the risk of going for it on 4th down (to use your example)? More generally, how does one know what is a “rewarding risky opportunity”?

    I’m almost positive that a lay user might not know how to best assess the risk of a given venture; hence we get people who either think something is risky when it is not, or vice-versa, leading to missed opportunities or worse, massive financial heartache. This is a HUGE problem in personal finance, I’ve found.

    What do you think?

    -A

  • http://www.mawsoft.com/blog RohoMech

    I think your laptop example could use more analysis. For instance, most consumer electronics have a low failure rate, and even the ones which fail could be because of a faulty batch of component X (like bad power supplies, bad batch of hard drives etc).

    Given this extra information, it should make the choice much easier to make. Another example would be for something like the Xbox 360.

    Given that you could buy a non-new one for cheaper, given that its warranty is for the same period, it makes more sense to buy the used one. Why? It turns out the device has a high failure rate, the reasons for the failure rate are intrinsic to the devices design, and the refurbished units have a better design.

    Granted, you can’t always get this kind of information, or worse, you’ll get misleading or incorrect information…but imo this is the kind of thinking that worst best.

  • http://www.mindyourdecisions.com Presh

    To Avnish: Good question about “rewarding risky opportunity.” I hope to give some examples in future posts where I discuss investments and specifically asset allocation. As for how a lay person can gauge risk, in financial examples, there are usually a few outcomes and we can estimate probabilities, so it is possible to estimate variance. I’ll give examples in future posts.

    To Rohit: I’m curious whether the failure rate is low and warranties are great for refurbished consumer products in general. I had a terrible experience with a Satellite company’s dvrs. The new one failed, and subsequently they sent two refurbished dvrs, which both failed. Though I have heard great refurbished product stories, my personal experience is that there is more risk to them.

  • http://www.mawsoft.com/blog RohoMech

    I’d argue the same notion is true for things like used cars. Its the asymmetry of information issue. Specifically, you as the buyer do not know what reason the used product is cheaper.

    But, here is fantastic link with some more information on the topic:

    http://hometheater.about.com/cs/beforeyoubuy/a/aarefurbinfoa.htm

    As you read the reason for why something might be sold as refurbished, it seems to make the option much more viable (less risky). Just as an anecdote, we’d bought a sub-woofer once that was open-box. We took it home, plugged it in, and…it didn’t work. The issue however was a missing fuse from the woofer. And the funny part? Back at the store, when we complained they just opened another woofer’s box and took a fuse out of it, thus ensuring another open box deal for someone else.

  • Avnish

    RohoMech, huh? Time seems to be standing still.

    And that woofer situation sounds a lot like social security. Only they’d have to take out two fuses to fix every one defective woofer thus ensuring a woofer crisis in 2028.

    -A

  • http://www.mawsoft.com/blog RohoMech

    Avnish, the point of that story is about the condition of the open-box item. It was really a new item that was missing a fuse, so in terms of reliability etc, it should work just like a new one.

    But, the buyer does not know these things, if there was a way to find out (people describe how they used their items on sites like ebay) then the price and trust placed in the item can both increase.

  • Avnish

    Absolutely, asymmetric information in the used goods market is a huge reason for erroneous valuation. In fact, one economic argument I’ve heard has been that if used car markets were efficient, they should always have lemons and no one should therefore buy due to the large discrepancy of information between buyers and sellers.

    But I was making a joke so that I could use the phrase “woofer crisis” and consequently feel both hip and somewhat ghetto. As you can see, it’s worked magnificently.

    -A

  • http://www.mindyourdecisions.com Presh

    Good link Rohit. Interesting that there are different categories of refurbished products like demo model or shipping damage.

    Doesn’t cover this category: my friend got a “refurbished” lcd monitor from ebay that had its serial number scratched out…

  • Joe P

    PATRIOTS ROCK!

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