How to take risks when managing your money? 3 lessons I learned to avoid poor money management

Managing your money is no easy task. Everybody wants to win, of course. But not everybody wants to bet, and therein lies a significant difference. There is no formula for personal finance management, the world of money is a world of pattern-less disorder, utter chaos.

Prices of stocks rise and fall in the short term because of what men and women are doing, thinking, and feeling. Your ability to invest and profit from it will depend on your risk appetite and on how well you deal with uncertainties.

Many people, probably most, want to win and increase their net worth without betting. This is an entirely understandable wish. There is nothing objectionable about it. Indeed, many of our hoariest old Work Ethic teachings urge it upon us. We are told that risk-taking financial decisions are foolish. A prudent man or woman places no bets beyond those that are required by the unalterable basic terms of human existence.

The three personal finance lessons that I will present in this post are the basics needed to set up your financial goals. I see a lot of people answering investor profile questionnaires and getting a good feeling for having an “aggressive” profile, or “Good risk appetite.” Indeed, higher gains are typically achieved with higher risk, but so are higher losses. Managing your money is more than just looking at your spending habits, it is also about making good financial decisions.

There is an old story about a fellow who stands on a street corner every day, waving his arms and uttering strange cries. A cop goes up to him one day and asks what it’s all about. “I’m keeping giraffes away,” the fellow explains. “But we’ve never had any giraffes around here,” says the cop. “Doing a good job, ain’t I?” says the fellow. It is characteristic of even the most rational minds to perceive links of cause and effect where none exists. When we have to, we invent them.

The human mind is an order-seeking organ. It is uncomfortable with chaos and will retreat from reality into fantasy if that is the only way it can sort things out to its satisfaction. Thus, when two or more events occur close, we insist on constructing elaborate causal links between them because that makes us comfortable.

It can also make us vulnerable, but we don’t usually think of that until it is too late.

Worry is not a sickness but a sign of health. If you are not worried, you are not risking enough. Perhaps freedom from anxiety is helpful in some ways. But any good speculator will tell you that if your main goal in life is to escape worry, you are going to stay poor. You are also going to be bored silly. If you want to avoid poor money management and make some cash while doing so, you must know how to take risks, and that means knowing how to speculate.

“All investment is speculation. The only difference is that some people admit it and some don’t.“

Geral Loeb

People who offer to counsel you in money management almost always call themselves “investment” advisers, not speculation advisers. It sounds more serious and impressive that way. After all, who will invest for retirement on speculative mutual funds?

But they are all dealing with speculation, they just don’t like to say it. Your financial advisor might not want to tell you, but when it comes to managing your money and making a financial plan, there will always be a speculative factor to it.

Lesson 1: Always play for meaningful stakes

“Only bet what you can afford to lose.”

… and chances are you will continue to be poor

You hear this wherever people risk money to get more money. Be it for paying off a student loan or saving for retirement. Be it in Wallstreet or Las Vegas, you read it in books of investment and money-management advice by conventional counselors. It is so often repeated that it has taken on an aura of truth through assertion. By the way, it is usually interpreted, it is a formula that almost always assures poor results.

What is an amount that you can “afford to lose“? What you have in your checking account or on your emergency fund?

Most would define it as “an amount which, if I lose it, won’t hurt.” A few hundred or thousands is what most middle-class people would consider loss-affordable. And as a result, these are the kinds of amounts most middle-class people speculate with if they speculate at all.

Your financial planner is not going to tell you, but consider this: If you bet $100 and double your money, you’re still poor.

Good financial education will tell you that the only way to beat the system is to play for meaningful stakes. This doesn’t mean you should bet amounts whose loss would destroy your personal finances and bankrupt you. You’ve got to pay the rent, put money in your retirement account and feed the kids, after all. But it does mean you must get over the fear of being hurt. If an amount is so small that its loss won’t make any significant difference, then it isn’t likely to bring you any considerable gain either. A few small gains will not change your financial future.

Lesson 2: Resist the allure of diversification

As used in the investment community, diversification means spreading your money around.

Spreading it thin. Putting your financial life into a lot of little speculations instead of a few big ones. The idea is safety. If six of your investments get nowhere, maybe six others will get somewhere. If one company goes bankrupt and the value of your stock drops to 3 cents, perhaps another of your speculations will turn out better. If everything collapses, maybe your bonds, at least, will increase in value and keep you afloat.

The fact is that diversification while reducing your risks, reduces by the same degree any hope you may have of getting rich. 

Most of us middle-class plungers, at the start of our speculative adventures, have only a limited amount of capital to play with. Let’s say you have $5,000 and that you are out of debt. You want to make it grow. What are you going to do with it? The conventional wisdom would say diversify. Make ten bets of $500 each. Buy $500 worth of Tesla, put $500 in a savings account in case interest rates go up, $500 into gold in case the bottom drops out of everything, and so on. There — you’re covered for all kinds of eventualities. It makes you feel safe, doesn’t it? Safe from just about everything — including the danger of getting wealthy.

Lesson 3: Always take your profit too soon.

Amateurs on Wall Street do it so amateurs in poker games. In reality, enthusiasts everywhere do it. They stay too long and lose. Always bet on the short and modest. Don’t let greed get you. When you have a good profit, cash out and walk away. Once in a while, you will regret having walked away. The winning set will continue without you, and you will be left morosely counting all the money you didn’t make.

In hindsight, your decision to quit will look wrong. This depressing experience happens to every speculator once in a while, and I won’t try to minimize it. It can make you want to cry. But cheer up, to match against the few times the decision to quit early turns out wrong, there will be a dozen others where it was the right call.

In the long run, you make more money when you control your greed.

Here is the cold truth:

Unless you have a wealthy relative, the only way you are ever going to lift yourself and become rich — absolutely the only hope you have — is to take a risk.

Yes, of course, it is a two-way street. Risk-taking implies the possibility of loss instead of gain. If you speculate with your money, you stand to lose it. Instead of ending rich, you can end poor.

Decide what your main goals are. Do you want to retire early? To buy a house? Do you want to get your kids’ college fees without incurring student loans?

Once you know where you want to get, do your homework:

• Understand your paycheck.
• Control your expenses.
• Get your debt paid off
• Improve your credit report.
• Eliminate your credit card debt.
• Have your retirement savings on a high-interest account
• Set short, middle and long term goals for your finances

Even after you accomplish all that, you are still not going to be wealthy. As an ordinary tax-hounded, inflation-raddled income earner, carrying much of the rest of the world on your back, you are in pretty sorry financial state anyhow. What real difference is it going to make if you get a bit poorer while trying to get richer? You aren’t likely to get much more miserable. But you can get very much wealthier. There is farther to go upward than downward — and no matter what happens, you will have an adventure. With the potential gain so much more significant than the possible loss, the game is rigged in your favor.

BONUS TIP: Want to booster your monetary self-awareness? Check this post I wrote about financial literacy, learn how to manage your money and take this free financial survey questionnaire. No e-mail, login, or registration needed!

Source and comments:

Only consider high-risk investing if you are debt-free. Getting out of debt can be challenging, consider getting credit counseling from a trusted financial advisor. Financial success is a long term goal, take one step at the time.

This post is based on my personal experience of more than 10 years of investing, and from lessons, I learned on the book The Zurich Axioms: The rules of risk and reward used by generations of Swiss bankers

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