Investment Options: Risk And Reward

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Why do investors regularly make the wrong choices?

Understanding why could prove invaluable when making your own investment choices.

Consider this: Investors love certainty and hate risk. 

All well and good!

But this, perversely, leads investors into making wrong choices.

Why?

Because they cannot differentiate between the levels of risk and reward.

The 'fear of loss' exceeds their 'aversion for risk'. This leads them into taking bad risks.

Not sure what I mean?

I'll give you an example. As an investor, which of the following would you choose?

• The option of losing $11,000 guaranteed
• A 75% chance of losing $15,000 with a 25% chance of not losing anything at all.

What did you choose?

If you chose 2., then, like most investor's, you let your 'fear of loss' overcome your 'aversion for risk'.

If you had put your logic hat on, you would have concluded that 1. was less risky. Why? Because 75% of $15,000 is $11,250 which is greater than the $11,000.

Not convinced?

Let's try something less taxing - tossing a coin. Would you accept this proposition?

• Heads you win $3
• Tails you lose $2.

Did you accept?

If you did not, then join the majority of people. But, should you have accepted the proposition? Well, as an investor you should have jumped at this excellent offer. From a risk point-of-view your potential gain exceeds your potential loss by 150%.

The 'fear of loss' is so powerful that it prevents investors from making good choices. The best investments, on the face of it, look poor at the point in time when an investment should be made.

This logic leads us to the conclusion that the least risk occurs, when investing in equities (UK = shares, US = stocks), when the equity is out-of-favour.

Why?

Because the upside, in terms of gain, is greater when the security returns to favor.

Similarly, the potential losses are less because the price is lower than if it were in favor.

Investors are also plagued with the 'fear of regret'.

How would you feel in each of these cases?

1. You buy an out-of-favour equity, having done all of the research that makes you believe that it is fundamentally sound, and the price falls still further.
2. You buy an in-favour equity (usually along with the rest of the investing community), and it looses value.

For 1. would you blame yourself for investing in a dud?
For 2. would you think that you were just unlucky in picking an equity that was just having a blip in its share price?

If you answered 'Yes' to either or both of these questions, then join the majority of investors.

In both cases this reaction is illogical.

It leads to investors purchasing highly regarded but poorly performing (in terms of return on investment) equities, in preference to out-of-favour, but potentially high performance, equities. They tend to accept the 'fear of regret'.

Investors overvalue highly regarded equities and undervalue out-of-favour equities.

This is the basis for the volatility of the markets. It leads to the waves of optimism and pessimism that culminates, eventually, in 'booms' and 'busts'.

Poor judgement of remote possibilities is also an investing problem.

This is borne out by the number of people that play the lottery. Which of these two options would you choose?

• A 1 in 50 chance to win $5,000
• A 1 in 100 chance to win $10,000

Which did you pick this time?

If you picked the second then you are one of the majority.

Most people choose the second option even though there is twice the chance of winning the smaller amount.

If you can overcome your 'fear of regret', then you will have a major advantage in making your investment decisions.

Make a conscious effort to analyse risk and reward in a sanguine manner - without jumping into an investment that, at first, appears to be the better option, because of your 'fear of regret' - then those investments will prove to be the most lucrative.

Always take the time to think before you leap.

Your instincts and emotions may say that one investment is better than the other when, in fact, the converse is true. Look at each option with cold logic and true knowledge of the components of a purchase, in order to achieve the most beneficial investment.

If you have read my previous articles you will know that investing in the stock market is more risky than making a deposit in a bank account.

Investments can be ranked according to the degree of risk involved.

The list below shows investment types with the least risk involved at the top, and the highest risk involved at the bottom

• Deposit accounts
• Short-term Gilts
• Long-term Gilts
• Property
• Most open-ended investments
• 'Blue Chip' equities
• Other domestic equities
• Foreign currency investments
• Overseas equities
• Commodities, financial futures and options

This list does not include every type of investment, just those that are recognisable to most investors. Tangible investments such as art, antiques and physical commodities could also be included.