How to manage your risk while investing?

Everyone knows that investing is a risky business. But what exactly is “risk”?

Economist Frank Knight classifies ignorance, uncertainty and risk in this framework:

  • Ignorance: You don't know the future states nor their probabilities.

  • Uncertainty: You know the future states, but not the probabilities.

  • Risk: You know both the future states and their probabilities.

Types of investors:

  • Dumb money operates on ignorance without understanding the possibilities and probabilities. They are likely following hype and acting instinctively on greed.

  • Accelerates and incubators deal with an enormous amount of uncertainty. While they do a lot of research into markets and interview founders to get a good sense of future states, the nature of the very early stage is that the probabilities of these possibilities are largely unknown. As a hedge against uncertainty, accelerators often invest in a greater number of opportunities than VCs.

VCs start moving into the risk zone especially when the probability of a founders vision [i.e proposed future state] becoming reality increases with market traction.

Understanding of future states and probability can be drawn from personal experience, deep expertise or education [ doing a lot of research or talking to experts]

Traction [ i.e customer adoption] is the most effective way to demonstrate favorable probability. And the degree that traction matters depends on the type and background of the investor. The more comfortable the investor is with using his own expertise and experience, the less he needs to rely on traction.

Not Trying is the Greatest Risk of All-

If we give in to our fear of risk, we guarantee the same outcome, regardless of the situation, you won’t get the thing you want.

Put in simple terms, every time we are faced with a decision that involves risk there are two possible outcomes

  1. A positive outcome

  2. And a negative outcome

Our brains trick us into thinking the negative outcome is more likely to happen than it is. We focus on the costs associated with a negative outcome when we make a risky decision.But we can always risk small losses.

What about the cost associated with foregoing the positive outcome by failing to make a risky decision? There is an opportunity cost for failing to take any risks.

Reframing Risk:

“If you think investing is risky, wait until they hand you the bill for not investing”.

Investing your money involves risk. It is possible that you could invest your money right before the next financial crisis. However, a true financial meltdown is far rarer than our brains would have us believe. That’s not to say we should throw caution to the wind, but we shouldn’t blow these risks out of proportion.

The risk of investment loss should be weighed against the opportunity cost of not investing. Assets that involve a lot more risk (like stocks) return a higher return on investment over the long term than if you stick your money in a savings account, which involves no risk.

To illustrate the opportunity cost of avoiding investment risk your entire life, consider how much money you would have at 65 if you started saving and investing Rs 1000 per month starting at age 25 under two scenarios.

  1. Where you invest your money in a “safe” asset that returns 5-7% per year on average.

  2. Where you invest your money in a “risky” asset that returns 12-15% per year on average (obviously it can be zero too because of the risk).

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