Everybody will find joy in gaining something and grief in the event of a loss. These emotions scale with the magnitude of the event, but one thing is constant: the psychological impact of the negative far outweighs that of the positive.
We’re hardwired to favor the processing of negative information. We pay more attention to unpleasant or painful events and recall them throughout our lives because this gives us an evolutionary advantage. For early humans, failure to swiftly learn lasting lessons from their mistakes, and those of others, could be fatal.
But the power of this risk aversion can permeate our lives, affecting decisions that have little to do directly with our survival, causing us to act along sub-optimal lines. This is evident in the realm of personal finance. How are you going to seize opportunities with a hard money loan, or build wealth with volatile assets, if you’re only focused on the potential negative outcomes?
Understanding how it works
Risk aversion may be hardwired into our behavior, but that doesn’t mean it’s entirely programmed into your brain. Neuroscientists have identified regions of the brain responsible for this disposition, and their relative prominence may vary with the individual. This means that biological differences determine where we fall along the spectrum of tolerance and aversion.
Equally, however, your socioeconomic status and cultural background will exert a strong influence in this regard. As you might expect, being wealthy helps encourage risk-taking. However, studies have shown that wealthy people in a poor environment are more likely to avoid risk than poor people in an affluent environment. People coming from collectivist countries are also more risk-tolerant than those from individualistic cultures.
And on a daily basis, we’re steeped in systems and exposed to influences that play with our risk aversion. At work, your company might structure performance rewards such that individual risk-taking is discouraged in favor of small but assured gains. Products or services you pay for on a subscription model are exploiting risk aversion by encouraging you to make them a part of your life, then fear giving them up.
Shoring up your sense of security
Thus, our tendency to avoid risk is in large part a learned and reinforced behavior. By increasing your awareness of where this is happening, you can minimize its impact, and actively work to counteract its effects. This is particularly valuable where personal finance is concerned.
Many people complain that they’re stuck in dead-end jobs that will never lead towards wealth and success. Yet they fear striking out on their own and starting a business, even though it offers the chance to earn exponentially relative to one’s time and effort invested. Entrepreneurship is risky. Earning a paycheck is guaranteed, even if it only allows you to make ends meet every month.
You can change this by building up your security net. Not all capital comes in the form of money. People with strong networks essentially take advantage of social capital. Through strong social ties, they are able to operate with a greater sense of security. They know that if they enter a risky venture, they can draw upon the expertise of professional connections to help. Strong relationships with family and friends can also give the emotional support needed to act boldly and decisively.
Gradually introducing and diversifying risk
Above all, however, risk-taking needs to be done smartly. And though financial risks like investing in a business, buying shares of stock, or owning real estate all come with inherent uncertainty, you can manage this behavior to mitigate downsides.
The Pareto principle states that 80% of your results come from 20% of your work. Nassim Nicholas Taleb, risk management expert and author of Antifragile, advises that you allocate your money along similar lines.
Maybe keep 85% of your wealth in stable asset classes like treasury bonds, which offer low returns but are guaranteed to keep your money safe. This helps you feel free to play fast and loose with the remaining 15% and invest it in high-risk, high-reward opportunities. After all, even if you lose that amount, it’s not like you’ve gone bankrupt. You can simply get by on a tighter budget, figure out how to earn it back, and rebuild.
By taking these steps, you’re not eliminating risk aversion altogether. It’s still vital to keeping impulsive risk-taking in check. You’re simply learning to play it smart and act rationally, free from the taint of fear or emotions that have become associated with loss throughout your life experiences. This clears your judgment and lets you act on opportunities to build wealth with minimal risk.