Worried About Risk? Try these Financial Tips
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On a daily basis, humans make decisions that involve an element of risk. It might be as simple as whether or not to take the airplane versus the bus as we weigh the risk inherent in each mode of transportation. The probability of the worst case scenario is often so minute that we make the decision to take the risk and board that plane because it is quicker.
In a study in which the subjects were given a choice to gain $500 for certain, or flip a coin and gain $1,000 for heads, $0 for tails – the subjects by and large chose the $500 demonstrating risk-avoidance. The study further examined loss by offering two options to subjects – one would be a certain $500 loss and the other would be to flip a coin and lost $1,000 for heads and $0 for tails. Again by and large subjects chose the option to take a chance on the greater loss as opposed to a certain, but lesser loss.
Categories of Risk Avoidance and the Behavior that Follows
The behavioral psychology discipline offers much research that demonstrates a strong correlation between human avoidance to risk and loss. Certain behaviors were identified in the research and pinpointed that in the area of money and finance, if nothing else, people would rather take a risk or gamble to avoid loss, revealing that the aversion to loss is greater than the aversion to risk. Psychologists created three paradigms or categories to describe the manner in which most subjects will approach risk.
Those who fall into category one ‘Risk-Averse’ would rather avoid risk altogether and seek any option that appears to be safer, in comparison. The next category is the ‘Risk-Neutral’ crowd who will engage in ‘reasonable’ risk taking with low odds of negative outcomes. The final group are the ‘Risk-Seekers’ who thrive on high risk situations – for example people who skydive or swim with sharks, despite the known risks inherent in the activity. Dr. Robert Anthony asserted that “Most people would rather be certain they’re miserable than risk being happy”.
When it comes to money and finances, the research in the behavioral finance discipline supports this notion as demonstrated in the study conducted by Dr. Daniel Khaneman and Amos Tversky (1979) when the majority of their subjects opted for the certain monetary gain, and took a risk to avoid a monetary loss.
Hedging on Financial Investments – Overcoming Fears
Due to the nature of aversion and the manner in which many humans demonstrate risk-aversive behaviors, it is not surprising that the first inclination for financial investors is to gamble a way out of trades that appear to be gaining momentum toward potential loss. On the flip side of that, when financial investments show promise, and there are definitive gains it goes against ‘human nature’ to hang on – for fear of losing the gains acquired thus far.
In all reality, if investors hedge in their positions it could prevent both risk aversion and aversion to loss behaviors and payoff in the long run with even larger gains. Professional investors know that hedging can be a very remarkable tool for financial gain. Traders and investors oftentimes fall short of their goals due to the aversive behaviors that prevent them from hedging. Some experts assert that hedging is the key to investment success. Begin with a simple hedging technique such as Stock Swap for better investment results.
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