Suppose a demon comes up to you and forces you to play a game where you will toss a fair coin. If the coin comes up heads you gain 20% of your total net worth. If the coin comes up tails, you lose 20% of your total net worth.
What percentage of your total net worth would you pay to banish the demon so that you do not have to play the game?
There is no right answer, although, in practice, savvy investors are happy to pay 4% to make the demon go away.
These are concrete examples of how a decent financial advisor can learn a bit about the risk tolerance of their clients. I don't think this is the practice here in the industry, but readers can use the book to confront FAs in Singapore just to look at their confused faces.
The end result of the series of questions is to get the answer to the following question :
- What the the overall risk aversion or lambda of an investor ? 1 = SBF, 2= ssavvy investor, 3=layman.
- To what extent is the time preference of the investor? What is the discount rate to make a $10,000 expenditure in one year equally satisfying as a $12,000 in two years?
The book acknowledges that even in these questionnaires, context will drive risk aversion and time preference. Wealthier people can delay gratification longer so can apply a lower rate of time preference. Poorer folks will prefer taking $19 today rather than $20 tomorrow. Risk aversion was found by researchers to be low at minimal levels of wealth, higher at median levels of wealth and then low again for upper echelons of wealth.
But this is certainly more interesting and useful than the fact-finding exercise conducted by FAs here who really want to know your salary to find out how much commissions they really can squeeze from you.
In the following chapter, a discussion was made about human capital which I have blogged about and taught a lot. All financial considerations should take into account the human capital of the investor. A civil servant with bond-like salaries can afford to take a lot more risk than a real estate agent with a strong market risk component in remuneration.
This is also one point that actual FAs in Singapore mostly fail to address.
A large part of the religious wars between the crypto, techno and dividends investors are largely due to differences in risk aversion and time preference. If we accept that it varies from person to person, we would have a more adult way to discuss the pros and cons of each investing style.
It should be normal that a guru to one can often be a goondu to another.
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