<FOOLISH WORKSHOP>

An Essay on Risk      

by Ben Goldman, Ph.D. ([email protected])

Weehawken, NJ (July 13, 1999) -- Harvard Medical School created a program for Universal Studios theme park in Florida that trains people how to overcome their fear of roller coasters.

Why would anyone bother to pay a specialist to overcome such purely optional torment? Some are just sick and tired of holding the sodas while the rest of the family has fun. Others want to conquer what they see as an unwelcome personal limitation. You know the drill: "There's nothing to fear but...."

Then again, there are those who aren't afraid of the eye-popping dips and climbs at all, they'd just prefer not to share their last meals with fellow passengers. For the queasy among us, even Harvard has no roller-coaster remedies. But they found techniques that dealt fairly effectively with the merely terrified.

Individual risk perceptions and tolerances vary from the extremely phobic to the extreme sports enthusiast. A highly complex variety of factors determines where each of us falls within this spectrum.

As investors, we are forced to take on risk. As good investors, we approach risk in a relatively rational and calculated manner. This requires good information and an understanding of the nature of risk.

Around here, people who are unfamiliar with the ways of Fooldom have been characterized as "Wise" or "emotional" investors (see Workshop founder Robert Sheard's book The Unemotional Investor). But is it irrational to accept reduced wealth in order to avoid the risks of market volatility? Maybe not: decisions about making and using money involve very personal reasons that defy simple notions of rationality.

There are two sides to investment risk: The objective statistical characteristics of the investments themselves, and the subjective characteristics of our response to these risks. When scientists compare how lay people and experts rank various risks, the resulting lists differ profoundly. The experts have a finite set of quantitative variables in mind when making their determinations involving the frequency, magnitude, and likelihood of the risk.

The perceptions of non-experts, on the other hand, are influenced by a much richer variety of qualitative factors: familiarity, dreadfulness, voluntariness, fairness, and so forth. These factors vary depending on an individual's past experiences, age, gender, education, family situation, health, socioeconomic status, etc.

So the answer is very complex indeed when each of us asks: "How risk averse am I, really?" There is good reason for some of us to avoid roller coasters entirely, and not just because of emotions or misplaced erudition. Fear isn't the same as plain old-fashioned motion sickness. Even so, the majority of us can indeed enjoy a good ride once in a while and can profit from the ups and downs of the marketplace.

The quantitative aspect of investment risk is the relatively easy side -- even a Fool can grasp the essentials. First, the market goes up more often than down. Second, a reasonable diversity of investments reduces volatility and limits potential losses. Third, the volatility of different investments can be measured and compared. Fourth, by also considering measures of return (such as the compounded annual growth rate, or "CAGR"), we can estimate which strategies are likely to provide greater reward for their risk. Fifth, once our nest egg is hatched, we can assess how much of our assets can be spent annually with minimal risk of depletion during our lifetime.

Dr. Michael Otto, the Harvard professor who created the "Coaster Phobia" program, uses three steps for overcoming roller-coaster fear. First, he provides accurate information about the degree of safety of the ride: how well they're harnessed into the seat; how well the coaster is attached to the track. That's our first step as well. You must first study the risk/reward characteristics of various Workshop screens to be able to use them in a way that feels comfortable at your risk tolerance level.

Next, Dr. Otto gets his wannabe coasters to focus on the core aim: to do something different with their experience of thrill -- to turn over their emotions to the roller coaster. As you read the comments of experienced investors on the Workshop message board, you'll see that they've learned how to let their emotions ride the market's ups and downs -- without letting their feelings affect their investment decisions. Or at least that's the goal.

I'll confess, for example, to being unable to resist buying a little more of my favorite picks when the market nears a high and then avoiding even looking at my portfolio during the big dips. It's only natural. Nevertheless, my portfolio remains unchanged until my pre-scheduled trading time, when I may make adjustments based on a review of updated, long-term risk/reward data.

Finally, before strapping them into the real thing, Dr. Otto creates accurate rehearsals that involve head-swirling dizziness and piercing screams. If you're just beginning with mechanical investing, or if you're tempted by a riskier strategy than you've used in the past, it's a good idea to experiment first with relatively small portions of your portfolio. This is certainly a less noisy method of gauging how you'll react to risk, but it can be just as gut wrenching.

The Motley Fool's credo is that it doesn't take rocket science to make good investment decisions -- anyone can do it. Yet we're not all fit to be astronauts. Some of those in Dr. Otto's program had fun when they finally rode for real; others got nauseous. But they all felt victorious, which is exactly how understanding the risk/reward trade-offs of investment decisions enables me to hold on during the inevitable, though temporary, plunges of the market.

An honest assessment of your own tolerance for risk is the first step in mapping out an investment strategy that's right for you. Whether you need to stay close to the ground or can't wait to fly high, there are plenty of Foolish investment options for you.

Remember: you don't have to be dizzy to be a Fool!

[For more on overcoming roller-coaster fear, see National Public Radio's "Rollercoaster" story from the Weekly Edition of May 15, 1999.]