The Math And Psychology Of Risk Taking

Psychiatrists and economists have opposite views on risk-taking. In psychology texts, taking risks is seen as a misdemeanor, even a disease that needs to be cured. However, in the economy, especially in the last two decades, taking risks has started to be highlighted as a virtue.

During training on innovation, I've come across many people who brag about having screwed up companies. Although these people had not yet created the thriving business of their dreams, they thought they were halfway there simply because they dared to take risks.

In an article about young people who started doing sports and eating a balanced diet, I came across the first example of a negative perception of risk-taking in psychology. The article's author mentioned avoiding risky behaviors while listing the achievements of young people. Maybe they even started to avoid crypto investment thanks to sports and a balanced diet :)

Psychology Of Risk Taking

When we search about the psychology of risk-taking, we come across events such as violence, drug use, traffic accidents, and risky sexual behaviors. The psychological basis of these behaviors is examined in articles on the subject.

The most popular academic study examining the links between risk-taking and personality was done in 1962. Marvin Zuckermann asked 260 college students about risky behaviors in 6 domains in this study. He then examined the link between these behaviors and the subjects' personality traits. Risky behaviors include excessive drinking, smoking, drugs, sex, drunk driving, and gambling. There are some differences between the 1962 personality definitions and today's, but in summary, the study found that extroverted, thrill-seeking, aggressive people are more likely to take risks.

Rüdiger M. Trimpop approaches risk-taking in a more balanced way in his book "The Psychology of Risk Taking Behavior." In his book, Trimpop states that especially young men are more prone to take risks and attributes this to the anxiety of finding a mate and gaining a higher place in the hierarchy. Risk-taking behavior is closely linked to survival. In his book Trimpop, he emphasized the importance of taking risks at an optimum level in the context of evolutionary psychology. The book contains many more detailed observations on risk-taking.

Risk Taking In Business

I've been in business for nearly 30 years. My observations during this time showed that taking risks is one of the primary conditions for success. There may be differences between the public sector and the private sector. My observations were mainly for the private sector.

In addition to courage, I can list being hardworking and having a sense of responsibility as success factors. Especially to be the boss of our own business, it is necessary to take risks.

Entrepreneurship culture differs from country to country. We know that entrepreneurship is highly valued in the USA and that innovation has become an essential value of the US economy. We can see cultural traces even in central banks' attitudes towards economic problems. During the 2008 crisis, the FED implemented monetary expansion rapidly, while the European central bank followed the FED behind, fearing inflation. The FED has already reacted to high inflation, our main schedule these days, and has taken bolder steps.

The Math Of Risk Taking

Like many other things in life, it is necessary to be moderate in taking risks. Since I studied industrial engineering, I can partially digitize the issue in my mind. All we have to do is take the optimum level of risk. Thus, we can maximize the expected net return. Multiplying the return potential and the probability of occurrence gives us the expected return. We get the expected net return when we subtract the potential for loss and the likelihood of its occurrence from the expected return. Verbalizing potentials and probabilities is easy, but converting these variables into numbers is not easy.

It has come to my attention that the most intelligent people I knew at the time of Covid-19 were also the most afraid of Covid-19. This coincidence means that it is necessary not to take life-threating risks. The financial equivalent of this situation may be not investing all of our money in a high-risk investment instrument.

We can predict the return potential of a financial asset by looking at its past performance. For example, the annual rate of return can be a measure we can use in this regard. On the other hand, the value of the financial asset we buy to obtain the said return may decrease. We also calculate the probability of depreciation based on price volatility. The financial asset we want to own should have high returns and low price volatility.

Finding digital assets with high returns in the crypto market is not difficult. It is tough to find assets with low price volatility. In this context, we can consider HBD, which provides a 20% annual return, as a jewel.

The Sharpe Ratio, which shows the risk-adjusted return, is found by dividing the return by the volatility. 1.29 for the 90-day Sharpe Ratio Hive. The rate in question is -0.11 and 1.45 for Bitcoin and Ethereum. You can access the Sharpe Ratios of significant cryptocurrencies at this link.

Risk-Adjusted Portfolios

Sharpe Ratio calculates the risk-adjusted return for a single financial product. It is also possible to create a basket of financial products at different risk levels to benefit from the return of high-risk financial products. Thus, it is possible to survive periods such as 2022, when risky assets lose value, with less loss.

Modern portfolio theory focuses on creating portfolios with low volatility and high returns when invested together. For example, financial products that are inversely correlated with each other can reduce the overall level of volatility in a basket.

The optimum point is usually somewhere between the two extremes. Therefore, precarious investments do not seem to be a rational choice.

Conclusion

Opinion leaders who express their opinions about our lives want us to be good children in our private lives. In business and financial matters, they prefer us to be people who can take measured risks.

The world is changing very fast. In the information age, taking risks has become a rising value. The economy is also transforming to reward those who can take reasonable risks.

Investors are divided into three groups according to risk tolerance: aggressive, moderate, and conservative. My tests on this subject show that I am an aggressive investor. I guess most of the people reading this article have a similar profile. The excitement in the crypto market keeps us alive.

Thank you for reading.

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