Money and You: Course Notes

Consider the following. You have the opportunity to play a game. It costs $100 to play. If you win, you will get $10,000. If you lose, you get nothing and lose your $100. Will you play the game?

Some of you may have said “no” right away. Some of you may have responded “yes” right away. For most, their answer will depend on information I haven’t given. In particular, the chance of winning will likely affect whether or not you’ll play the game.

Suppose I told you there is a 99%of winning the game. Given the large prize amount, many people would chose to play the game. Suppose I said there was a one in a million chance of winning. Many people would chose not to play the game. Notice an important observation. There is a risk of losing $100, and your willingness to risk that $100 depends on the chance on being rewarded with winnings.

Let’s flip things around a little bit. Suppose you have the same game that costs $100 to play. Also suppose that you know the chances of winning the game is 25%(one in four). If the amount you could win was $200, would you play? What if the amount you could win was $10,000? You are probably much more willing to play with the higher possible winnings amount. Again, based on the risk, you want a certain amount of potential reward for taking on that risk.

One of the most important concepts in finance is the notion of risk and reward. Risk refers to the possibility that you will lose some or all of the money you invest. Reward refers to the concept of potentially earning money for taking on risk. That is, the riskier an investment opportunity is, the higher the reward you would expect for taking on the risk. Conversely, the higher the reward for an investment, the more underlying risk will be involved. This concept is known as risk vs. reward.

Every investment opportunity comes with a level of risk. However, how much risk someone is willing to take on varies greatly from person to person. Someone who is more inclined to take on riskier activities is called risk tolerant. Someone who is less inclined to take on riskier activities is called risk averse. Risk tolerance heavily tied to some of the common money biases. For example, people with higher loss aversion bias tend to be more risk averse.

In general, there is no “good” or “bad” level of risk tolerance, with the exception of extreme risk tolerance or aversion. Someone with extremely high levels of risk tolerance has a greater chance of taking big losses eventually. Someone with extremely low levels of risk tolerance will miss out on opportunities to accumulate wealth. However, the majority of people lie in between these two extremes.

Below are some questions related to risk and reward. For each, select the answer that best matches how you think or would behave. At the end, you will be asked to write a brief reflection on your answers.

It is very difficult to classify someone into a category or risk-tolerance level. Risk tolerance is a spectrum, and that spectrum also depends on various facets of like. A sky-diving instructor may be fairly risk-averse when it comes to money. Someone who is very risk averse when it comes to physical activities may be a thrill-seeker when it comes to money. So, instead of tallying up points to put you into a category, instead you should look at your answers and think about what they may say about your tendencies to money.

For each question, the answers go from most risk averse to most risk tolerant. That is, (a) is the most risk-averse option, and the later letters are more risk tolerant. Write a short paragraph reflecting on your answers and what they may indicated regarding your risk tolerance. Would your answers indicate that you are more risk tolerant or more risk averse? Why?