Elizabeth Kerr ponders how much risk you can handle and how this changes as you age

By Elizabeth Kerr

If I’m left alone for too long chances are I’ll come up with a hair-brained money making idea, and spend the rest of the day convincing anyone who will listen of its merit.

This is what happened last weekend, which resulted in me asking a bunch of people whom I know appreciate a healthy and physical lifestyle to bet on themselves (and by default each other).

It went something like this:

• The buy-in price is $50.
• Each person was to log a run each day of at least 1 mile.  
• If they missed a day they were out of the competition. 
• The last person remaining got to keep all of the money (10 people =  $500).

In addition to those rules everyone was entitled to one “buy-back” day: IE, if they missed a day, and they still wanted to be in the competition, then as long as they logged a run within 24 hours of the missed day AND paid in an additional $20, they were back in the game. That raised the possible return to $700 for the last runner standing.

The amount of $50 was chosen intentionally as being adequate enough to ensure some sort of commitment but not too low that come a rainy day people felt entitled to “spend” $50 to stay inside and not participate.

It seems simple enough right? Well there is a little more to it…

Like poker, you never really know what cards each other player has. Similarly in my game no one knows the other members of the group. No one knows if the group is made up of regular runners or couch potatoes, so, that is all part of risk with the investment. Maybe one good ol' Wellington southerly would force half the pack to retire? No one would know...

What was interesting to me was what people focused on when evaluating the decision to get involved or not.

Approximately half of the recipients first focused on the initial investment being $50 - providing responses such as “$50 is a lot of money”, “we’re on a budget at the moment” or “I’m saving for my 40^th” and the like.  

The other half was first motivated by the $500 prize pool. “That’s a great incentive”, “wow a great return on my money”, “I’ll run on a broken leg for that”. Only one person said they wouldn’t participate because they can’t run everyday.

All three approaches to evaluating their $50 investment are a valid way of thinking about investment risk. (Although I think the person who said they can’t run everyday had the soundest logic of them all.) Regardless, I think this is somewhat reflective of how people think about money and investment risk in general: IE, some people focus on the possible returns from an investment and then weigh up the risk before deciding whether it’s worth handing over their money. And others only think of what they are investing first, regardless of what the returns “could” be, as though they are going to loose that money forever.  

I think that it’s worth having a good look at yourself and figuring out what sort of investor you are so you know how much risk you can tolerate, how much risk you need and your ability for taking risk. This is the topic for today’s column.

What is risk tolerance?

It’s hard to define and is different for each person. I like to think of it as my ability to stomach losing money; or the amount I’m willing to invest and still be able to sleep well at night. It’s the reason that some people say they wouldn’t touch a particular investment with a barge-pole; yet the next person is right on in there like a fly on hot dung.

Age & Need

Some people further define risk tolerance age. For example, if you are in your early 20s then it is assumed you will want to be enthusiastic with your investments to maximise the potential of them  earning you as much money as possible. And, hey, if it all goes belly-up you’ve got youth on your side and can just start again all the wiser. Right?

The opposite is assumed for those nearing 65 and possibly retirement. It is assumed that at this stage in life you will need to go in the opposite direction to the above and be conservative, investing in your mattress, a piggy bank or the safest of cash accounts and term deposits, because losing money at this late stage of your working career would have a direct effect on your lifestyle.

If you were nearing 65 and had no retirement savings set aside then your NEED for risk would be high in order to try and maximise as much return on your investment before retirement.

I know I harp on about starting investing early in your life, not just so that you get into the habit of living on less and have a better chance of utilising the power of compounding interest…but its also because the earlier you start the safer, more reliable, and less risky choices for investments you can make.  

The last thing you want to be doing in your 60s is placing the little that is left over after a few decades of excess consumption on the nose of a nag at the races hoping that it will win and fund your retirement years. That is a very risky investment indeed!!  

But age and need are not always an accurate way to ascertain risk tolerance and you would do well to ask yourself some more pertinent questions too.

So, what else can we think about...

Risk Capital…(ability to take risk)

Basically this means if you can’t afford to lose it then don’t invest it. For example: I never want to invest into anything that will put my personal home at risk of having to be sold. This is not the same for everyone.  

You might ask yourself: “If the money I invested was lost would it really matter?  Would it affect my lifestyle or make me depressed?" Do you have enough wiggle room in your finances to sit out the low/no dividend payouts or rental vacancies while waiting for things to improve again?

Regret Minimisation

It is said that Amazon CEO Jeff Bezos runs his life on a “regret minimisation” framework. He wants to look back in life and regret as little as possible. So, from this perspective you might ask yourself: “Is there a good reason NOT to take the risk by making an investment?”

It is often for this reason that people come out with things like “seize the day” or “no one died wishing they had more money” or “life is short, just do it” as they are about to spend money they know deep down inside they probably shouldn’t. But on the flip-side of those decisions there are a hell of a lot of people out there who regret not being smarter or more prudent with their money and earnings while they had it so good.  

So, since we’re on the topic of “risk minimisation” – you can be sure to have few regrets in your later years if you embrace saving for your money machine at the same time as designing your lifestyle with what is left over. That’s called having a balanced attitude and will ensure you are satisfied either way.

What is the antidote to risk?

Education!

1. Education is the only way you can equip yourself to evaluate the risks of investment.

For example: pluck a random person off the street and ask them to fly a 747 and chances are high they will fail and crash. Give them a “Flying for Dummies” handbook and you might fare slightly better… But educate them on how to fly a 747 and chances are you will have success.  

It is the same with investing for your money machine – the more you learn the better your chances are of having a successful outcome.

2. Know why you are investing in the first place.

The other key is to really understand why you are making an investment in the first place. What do you hope to get out of it? How will it help your money machine goals? How long will it take to get your money back? What could go wrong and what would this mean for you?

The biggest risk of all is to do nothing!

I’ve said this before and I’ll say it again today - It is bloody hard work “saving” your way to retirement using just your piggy bank; so somewhere on the journey you may want to make some investment choices and this will likely involve embracing some level of risk.  

As for running poker *laughs*… It won’t exactly fill up your money machine but if you fancy giving me a good run for my money (no pun intended) then email me on Elizabeth.Kerr@interest.co.nz by the end of the week.