Your investment drops 20% in a month. What do you do? Sell everything to stop the pain? Wait and touch nothing? Buy more, because "it's the sales"? There's no wrong answer. But your answer says a lot about your risk profile.
Our brains hate losing
In 1979, two psychologists, Daniel Kahneman and Amos Tversky, asked volunteers some very simple questions.
- Would you rather have 3,000 for sure, or an 80% chance of winning 4,000? 80% of people take the sure thing.
- Would you rather lose 3,000 for sure, or face an 80% risk of losing 4,000? This time, 92% choose to gamble.
When we can win, we play it safe. When we might lose, we take risks to avoid the loss. It isn't a character flaw: it's simply how our minds work. Knowing it helps you avoid the trap.
The three animals
- The tortoise hates being shaken about. She'd rather go slowly and sleep soundly.
- The hedgehog keeps up a good pace, but knows how to curl into a ball when danger approaches.
- The lion aims far and accepts the odd fall, because he knows he'll get back up.
A worked example
Three families each invest CHF 10,000 for their child. In this simplified model, shares return 7% a year on average but lose 30% in a very bad year; bonds (loans to a government or a company) return 2.5% and barely move.
- Tortoise (20% in shares): bad year, −CHF 600. After 15 years, about CHF 16,510.
- Hedgehog (50% in shares): bad year, −CHF 1,500. After 15 years, about CHF 20,060.
- Lion (80% in shares): bad year, −CHF 2,400. After 15 years, about CHF 24,310.
More expected return means more bumps to put up with. There's no such thing as a free lunch.
The right profile is the one you stick to
In 1952, the economist Harry Markowitz (later a Nobel laureate) showed that you don't have to choose just one animal: by mixing investments that don't all move at the same time, you can keep a good return with fewer bumps.
So the best profile isn't the bravest one. It's the one you'll stick to when everything falls. A lion who sells everything at the first storm ends up worse off than a loyal tortoise. Two questions help you choose:
- In how many years will I need this money? The further away, the more room for the lion.
- Will I still sleep if it drops by a quarter? If not, add more tortoise.
Try this tonight with your child
Play the three envelopes game. Put 10 counters in each. Tortoise envelope: you always keep your counters, plus 1 bonus. Hedgehog envelope: toss a coin, heads +3, tails −1. Lion envelope: roll a die, 5 or 6 = +10, otherwise −3. Your child chooses before playing. Afterwards, ask: "Would you make the same choice again? Why?"
Read also: The stock market rollercoaster
Further reading
- Kahneman, D. & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263–291.
- Markowitz, H. (1952). Portfolio Selection. Journal of Finance, 7(1), 77–91.
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Educational content, not investment advice. Returns are not guaranteed. The figures come from a simplified model and are not a forecast.