Your Relationship with Risk
I’m Andy Temte and welcome to the Saturday Morning Muse! Start to your weekend with musings that are designed to support your journey of personal and professional continuous improvement, and to improve financial literacy around the world. Today is April 5, 2025.
Today, we continue our adventures in financial literacy with our first episode on the topic of risk. How we navigate our personal relationship with risk has a profound impact on many aspects of our lives, yet we spend very little time and energy actively thinking about how we feel about it.
Instead, we allow our subconscious to drive the bus and end up reacting to risk instead of taking a more proactive approach. This more reactionary approach to dealing with risk sets us up for suboptimal decision-making because our cognitive biases unduly influence the decisions we make. To learn more about cognitive bias, please go back and listen to the two episodes on the subject from early March of this year.
To be clear, how we feel about risk and how we respond to risky situations is not applicable solely to the financial investments we make. Our feelings toward risk influence what jobs we pursue, the relationships we engage in, the products we buy, and the recreational activities we take part in. Your personal relationship with risk touches and helps shape nearly every aspect of your life.
So let’s start at the beginning. What is risk?
Merriam Webster defines risk as the possibility of loss or injury. In financial terms, Investopedia defines risk as the chance that an outcome or investment’s actual gains will differ from an expected outcome. Risk includes the possibility of losing some or all of an original investment.
So put simply, risk can be thought of as the probability that an investment or activity will not yield an expected outcome or result.
Note that there is always some type of expectation that sets the baseline for the size of the risk that you face. You expect that your car won’t be damaged when you’re standing in the showroom contemplating the initial purchase. You expect that the big vacation you’re taking will go as planned. You expect that an investment will yield a particular return when you buy it. You expect that a job will go well and provide an appropriate set of opportunities when you take it. As we all know, the actual outcomes after we’ve made our decision can vary greatly.
The other primary component of risk is probability, and the distribution of potential actual outcomes. If the actual results of an investment or activity are exactly the same as what you expected to happen every time, then there is no risk. However, once actual results begin to vary from expectations, then risk is present. As the range of potential actual outcomes around the expected outcome increases, risk increases.
Let’s tackle an example, let’s suppose you have $100 to invest and there are only two investments you can make. Also, we’re going to assume that you must sell this asset in one year.
Investment 1 has a 50 percent chance of ending the year at $200 and a 50 percent chance of ending the year at $50 - the range of potential actual outcomes is wide, indicating greater risk.
Investment 2 has a 50 percent chance of ending the year at $130 and a 50 percent chance of finishing at $120. Here, the range of potential actual outcomes is much more narrow, indicating lower risk.
Both investment 1 and investment 2 have the same expected outcome of an ending value of $125 — this is the probability-weighted average of the two potential actual outcomes. For now, let’s not worry too much about this calculation, we’ll be talking about simple return calculations later in this series.
What’s important is that both investments have the same expected outcome to keep things simple and to focus our attention on the range or width of potential actual outcomes around the expectation. It should be clear that investment 1 is a much riskier proposition relative to investment 2 because although you have a chance of a much higher actual outcome with investment 1, you also have an equal chance of losing 50 percent of the asset’s value in one year!
Introducing the Concept of Risk Tolerance and Risk Aversion
Your decision of which investment to choose depends your level of risk tolerance, or conversely, your level of risk aversion. Since we know from our discussion of cognitive biases that investors suffer from loss aversion—where the discomfort of a loss is perceived as more significant than the satisfaction experienced from a gain of the same amount—we typically think about our relationship with risk as not tolerance, but aversion.
You may be wondering if humans are naturally predisposed to be risk takers or risk avoiders? The answer seems to be a balancing act between the two ends of the spectrum. If we remove the artificial comforts of modern life and think back to our behavior in simpler times, to survive, we had to be bold. We had to take risks to secure food, shelter, warmth, mates, etc. Simultaneously, we had to avoid taking unnecessary risk to secure food, shelter, warmth, etc., to minimize the likelihood that we would sustain an injury we couldn’t recover from. Hence, loss aversion likely stems from the potentially catastrophic nature of bad outcomes—before the advent of modern antibiotics, you could die from even minor injuries.
So in a modern context, how can you get a sense of your relationship with risk? How risk averse are you? Here, it’s important to note that you are a one-size-fits-you human and your relationship with risk is specific to you. Just like our previous conversations about change, or your definition of success, it is dangerous to adopt someone else’s definition of, and viewpoints toward, risk. It’s essential that you do this work yourself.
Fortunately, there are a few free tools available to help you get a sense of your level of risk tolerance/aversion. Your homework this week is to take a personal risk tolerance assessment. Most financial advisors have risk tolerance assessments, but to avoid the perception that I’m trying to sell you something, here are two simple free assessments from independent, non-advisory sources you can check out.
University of Missouri Division of Applied Social Sciences Investment Risk Tolerance Assessment
British Columbia Securities Commission Risk Tolerance Assessment
So that’s where we’ll leave it for this week. Next week, we’ll talk about what to do with the results of these assessments and we’ll begin exploring the relationship between risk tolerance/aversion and personality traits like self-confidence.
Grace. Dignity. Compassion.
