Magnitude of Risk (The Financial Athlete #132)

Playing a high impact sport with an injury risks worsening it to a chronic one. Caught in the heat of the moment during an exciting game, it can be difficult for the athlete to consider the magnitude of this risk. Likewise, the investor must consider the magnitude of risk.

Take, for example, the following simple scenario.

Initial investment: $1000
60% probability of 3 x return = $1,800
10% probability of 10% loss = ($10)
30% probability of 100% loss = ($300)

Expected outcome: $1,490

This investment may be tempting. Who doesn’t want to make an investment with a expected return of 49%. Now let’s suppose someone were to invest 80% of their net worth on this one “promising investment” and the outcome turned out to be the worst case scenario of 100% loss. The loss could be devastating, especially if the investor were nearing retirement age. Hence, the magnitude of risk for this investment is too high if overweight on it.

Always pair up an analysis of probability with magnitude of risk to determine how much should be invested. Too many investors fail to consider the magnitude of risk. This dumbs down the process of investing.

“Things should be made as simple as possible, but not simpler.”
— Albert Einstein

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