A retired low 7-digit millionaire in her 70s recently told me that her instructions to the wealth manager investing her family’s portfolio is “just don’t lose any of our money.” Of course, a reputable and candid wealth manager can’t possibly guarantee such an outcome, unless he/she puts all of the family’s money into government-insured certificates of deposit. Even then, returns from CDs are unlikely to keep up with inflation, so they are subtly “losing money.”
Risk aversion and loss aversion are behavioral characteristics inherent in any type of activity in which assets can appreciate or depreciate. For instance, the activity can be investing/speculating in stocks, bonds, real estate, or commodities…or betting on sporting contests and horse races. Research in behavioral finance has yielded quite clear findings on people’s propensity for risk aversion and loss aversion whenever there is money on the line and there can be winners and losers.
Risk aversion refers to people’s usual emotional preference for safety and certainty. Given the choice between a 75% chance to win $100 and a 50% chance to win $150, most people would select the former, notwithstanding that the choices have an identical expected value of $75.
Loss aversion is a form of risk aversion but is not the same. The website The Emotional Investor succinctly sums up the difference: “Loss aversion is not just the desire to reduce risk; it is an utter contempt for loss.” The woman who instructed her wealth manager not to lose any money is extremely loss averse…and unrealistic.
The vast majority of horse racing bettors are not loss averse or they would not be betting on horses at all. Bettors who consistently wager on favorites are risk averse, whereas other bettors are venturesome and take chances on longshots. Adept bettors closely adhere to the concept of underlays and overlays and try to capitalize on the latter, much like an investor seeking a value common stock.
It would be informative to do behavioral-finance type research among people who breed racehorses and buy and sell them at public auction as weanlings and yearlings. People who engage in these highly speculative ventures (such as pinhooking) almost certainly have a much more tolerant risk profile than the overall population. They would probably fall into the same category as the most risk-taking entrepreneurs, like frackers and funders of Broadway plays.
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