Testing Your Return & Risk Taking Profile

Stephen Chung

Managing Director

Zeppelin Real Estate Analysis Limited

December 2006

When it comes to investing, many people tend to categorize investors into 2 broad types, namely the aggressive and the conservative. Naturally, the media usually would love to do a story on the former, the huge bets they take, and the overnight enormous profits they make, i.e. when their investments are successful. Also, some of the aggressive may appear so because they do not fully understand the risks involved, while some in the conservative camp may be so because they over-estimate the risks involved. There is probably no right or wrong in selecting a return & risk combination, only whether it is suitable to the investment requirements and resources available. In any event, investment often means finding the best return possible within certain risk criteria or limits. 

Here we offer a simple framework for finding out and testing ones taste for return and risk taking (or tolerance): 

A)     There are 2 investment opportunities, one offers a return of 100% and the other only 50%, assuming the same capital amount, investment nature, and timeframe etc = which one would you choose? [note = this is NOT a trick question]

 

B)     Your humble author believes most, if not all, of the readers would tend to pick the investment opportunity which offers 100% return = now, if you are told that 100% return opportunity comes with a risk of losing 50% of the capital, while the 50% opportunity risks only losing 25% of the capital, assuming all else being equal including the probability of losing 50% and 25% respectively for each of the investment opportunities, which one would you select? [note = again this is NOT a trick question]

 

C)    Your humble author at this stage believes that some of the those who have previously opted for the 100% return opportunity may now have second thoughts and could have switched side to the 50% return (but 25% loss) opportunity = though do note both opportunities offer the same return to risk ratio of 2 to 1 (100% to 50%, and 50% to 25%).

 

D)    Big investment, small investment = obviously, the amount of capital or equity required would have a bearing on the choices. For instance, if we are talking about investing just US$100, most would probably opt for the 100% (lose 50%) opportunity, even for the conservative bunch. BUT if the investment amount is US$1,000,000 and is your own money (not other peoples money), your humble author is quite certain that most would probably have opt for the 50% (lose 25%) opportunity, IF one is obliged to invest.

 

The overall point is that investment does not just relate to economics, finance, markets, demand, supply, and the dozens of factors dished out by proponents of investment. It also relates to ones goals and objectives, and also to ones character and values. It also relates to whether you are facile with a particular type of investment, e.g. a real estate expert may reduce part (seldom all) of the risks involved in real estate (via various tactics and strategies) because he or she knows the business versus someone not in the industry.

Notes: The article and/or content contained herein are for general reference only and are not meant to substitute for proper professional advice and/or due diligence. The author(s) and Zeppelin, including its staff, associates, consultants, executives and the like do not accept any responsibility or liability for losses, damages, claims and the like arising out of the use or reference to the content contained herein.                                

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