02 Understand Investment Risks

All investors hope to make profits. But every investment involves risk, so there's always a possibility of losing money.

Investors suffer losses partly because they perceive risks in the wrong way. So, if you can understand the risks, you'll be benefited in two ways.

The first major benefit is to potentially reduce losses.

Why? First of all, let's look at a psychological theory called loss aversion.

Let's take stock investing as an example. Suppose you bought a stock at $10, and it quickly went up by 20% to $12. Would you sell it right away to take profits?

But on the flip side, if the stock price dropped by 20% to $8, would you rather hold it for a rebound than exit the position at a loss?

In other words, investors tend to be more risk-averse and want to realize a profit as quickly as possible, no matter how small it is.

However, when they face a loss, they tend to exhibit more risk-taking behaviors in the hope of reducing losses.

These are the common loss-averse behaviors among investors.

But if the stock moved even higher after the 20% advance, you could regret your early exit.

On the other hand, if the stock price continued falling after the 20% decline, you would keep losing money until you sold it off.

Suppose the money-making and the loss-making positions each took half of your portfolio. The profit would be way smaller than the loss as you tend to sell winners too early but hold losers too long.

So, is loss aversion helping or hurting your portfolio return in the long run? You've got the answer.

Having said that, how to understand investment risks exactly? We should try to avoid the impact of loss aversion.

Buying a rising stock does not necessarily entail higher risks. Similarly, investing in a falling one might not be a safer choice. It's also not wise to base your investment decisions solely on realized gains or losses.

If you can avoid this psychological trap, you may build a more healthy portfolio

and are less likely to suffer greater losses.

The second benefit of understanding risks is to give you a clearer picture of investing.

Every investment involves risk. So many people put all their money in banks for fear of risk.

But the risk goes hand in hand with the return. In other words, if you want to have higher returns, you must take higher risks.

In some markets, stocks have considerably outperformed cash over the past decade.

For example, the compound annual return of both the S&P 500 and Nikkei 225 exceeded 10%, much higher than the interest rates offered by banks.

Though past performance does not necessarily indicate future trends, risk-averse investors may have missed great investment opportunities altogether.

To wrap it up, we've mentioned two common loss-averse behaviors, but actually, there are more.

If we can avoid this psychological bias and understand investment risks, we may comprehend the meaning of investing to minimize potential loss and maximize potential gain.