Risk vs. Reward: Why We’re More Blind to the Former?
Some personal observations and a set of recommendations
It’s natural for one to take big risks believing that it would lead to big rewards.
If you aim to win big, it’s fair that the risk you should take is proportionally big as well. It’s fine! Though I want to talk about a couple of problems with this way of thinking.
When the “big risks” and the “big rewards” are together in a statement, our brain focuses more on how “big” the reward is and avoids the second “big” next to the risks.
While making an investment, starting a business, making consequential choices, and even giving small daily decisions, if the upside is highly appealing, we’re in danger of being blind to what’s at stake.
A study suggests that rewards gleam more brightly when we’re under stress (Mather & Lighthall, 2012).
It’s rational to risk 5 dollars to win 100 dollars if the probability of success is more than 50%. Yet even in gambling where the odds are systematically against our favor, people think it is worth the shot.
If we have a sneak peek at the gambling stats in the U.S:
- About 85% of adults in the U.S. have gambled at least once in their life.
- The gambling industry takes in about $500 billion a year.As many as 23 million Americans go into debt because of gambling.
- The average loss of those 23 million people is estimated to be around $55,000(Debt.org).
The promise of astronomic returns shines so hard that it makes one blind.
There are many scientific explanations for this preference, yet as I am not a behavioral psychologist, I’ll just share some observations and mostly look at it from an investor’s perspective.
Effort ≠ Return
If the effort were always equal to return, reading hundreds of books about investing would have taught you all the strategies that work out the best. Then you would just execute them with the rules by the book and reach your promised success. Yet, being the best learner of something will never make you the best executioner of it.
History is full of failed investment professionals who dedicated their big brains and lives to financial markets.
Your knowledge and previous successes in a field may make you feel invincible. It’s because historical data is our primary tool to make forecasts for the future. If the same investment strategy was a success in your last 10 investments, then your 11th is guaranteed to be a big hit as well, right?
Unfortunately, that’s not the case most of the time. Your accumulated knowledge through success can be useful as leverage in your following endeavors, but past events do not change the probability that certain events will occur in the future.
Even if a stock went up 10 times after a certain event, it doesn’t mean it’ll go up again in a similar situation. This wrong way of thinking is called Gambler’s Fallacy.
Why do we keep falling into this trap?
Success is a lousy teacher. It seduces smart people into thinking they can’t lose. — Bill Gates
One reason for falling into Gambler’s Fallacy and giving more chance to the favorable results is not because we trust in our luck so much. Quite the opposite. It’s due to avoiding the fair share of luck in our successes.
Luck sounds such a positive word that we forget that it can also work against us. The coin you flip has no memory. Even if you got tails three times in a row, the possibility to get another tail for the fourth time is still fifty-fifty.
Denying that the edge you have against a certain probability may be associated with luck would lead you to claim full credit for past successes, which may result in overconfidence.
Self-confidence is a safe harbor to find the fuel to take risks, be brave to try, fail, and learn. Yet overconfidence barely returns positive results in the long term.
If you start believing that you will never fail, congratulations! You’ve just doomed yourself to fail big time eventually.
What should I do?
Admit that future success is not for granted, and luck may also turn against your favor once in a while. You will then be more cautious and ready to do whatever it takes to mitigate your risks as much as possible.
Here are a few recommendations from my side:
Take Rationally Optimistic Bets with Big Upsides
I’ve heard this recommendation from the co-founder, chairman, and former CEO of AngelList, Naval Ravikant, for the first time in his podcast. It’s spot-on advice in this case.
There are two components to this recommendation. One of them is that look at the bets that are statistically in your favor.
This doesn’t mean only get bets with more than a 50% chance, but at least be aware of the probability, so you can decide afterward if the reward outweighs the risk. Calculate the risk/reward ratio of the bets you take.
If a stock has been crashing down for the last five years, know that the possibility that it’ll magically flip to the upside just because you bought it is very low unless something fundamental has changed about the company.
The second component is the big upsides. Even if you have a 51% chance of winning a bet, risking your nine dollars to make ten dollars don’t make any sense. There is still a 49% chance that you’ll be losing 9 dollars in the end. The risk you take should worth the reward.
Admit Easily When You’re Wrong
Never take it personally when the markets move against your interest. There is nothing wrong with being wrong in the financial markets. All the investment professionals choose bad stocks, get greedy, be overexposed to certain asset types. We’re all human, after all.
Unlike many, people who succeed in investing can admit that they are wrong, step aside, and look for the next deal. For example, recently, Warren Buffet admitted that he made a mistake with his investment of approximately $8 billion to airline companies, and he sold all his positions.
Once you admit that you’re wrong, it provides you space to consider the new possibilities and plan your next steps accordingly.
One way of admitting your mistake in financial markets is to realize a loss and not growing it too much by cutting your losses early.
Cut Your Losses Early
If you lose all your capital in an endeavor, you’ll never have a chance to try again.
Risk only a rational proportion of your portfolio in investment. If you’re day trading, make sure to set a stop-loss limit order before you even enter a position.
If you’re investing, keep a close eye on your losing positions. If the company is not performing for the better and doesn’t have a bright future ahead, cut the loss and seek new opportunities.
This is all OK!
Take Some Profits In Pre-defined Targets
Once we build our portfolio and watch it grow day by day, it seems like the upside is infinite, and you should never interrupt it. Yet, nothing grows forever.
When people thought that internet companies would grow forever, the dot-com bubble burst in 2000.
When the majority of the world was convinced that real estate was the most reliable asset available to everyone and would never stop going bigger, the housing market crashed globally in 2008.
Everyone invested in cryptocurrencies was sure that they would never have to work another day in their life when they joined the ICO bubble in 2017, which burst in a couple of months and wiped out the 99% of the value of some altcoins.
The point is that if you make a significant amount of money in any of the assets, it’s fine to take profits once in a while to be on the safe side. At least secure your initial investment after making 5x, 10x, 20x from it.
A profit that you don’t realize has never been truly yours.
My main message here is that although the way to gain big rewards may come from taking big risks, not every reward worths the risk, you’re taking.
Don’t underestimate the contribution of luck in your previous achievements.
Avoid the Gambler’s Fallacy and consider the probability of each event happening, independently from your previous experiences, as much as possible.
Once you set the base of a healthy mindset about risk and reward relationship, use the following strategies to minimize your losses and secure some gains:
- Take Rationally Optimistic Bets with Big Upsides
- Admit Easily When You’re Wrong
- Cut Your Losses Early
- Take Some Profits In Pre-defined Targets
This article is originally published on Medium.
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Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. Use this information at your own risk.