This is Part 7 of my nine-part series connecting financial frameworks with personal growth.

1.      Finance as a Framework

2.      Assets = Liabilities + Equity: What You Own Comes with Strings Attached

3.      Assets = Liabilities + Equity 2: What You Have vs. What You Can Use

4.      Time Value of Money 1: The Power of Compound Interest

5.      Time Value of Money 2: Why Humans Use Bad Discount Rates

6.      Risk and Return 1: No Risk, No Return

7.      Risk and Return 2: Why Humans Are Bad at Calculated Risks

8.      Risk and Return 3: Diversification and Building Multiple Pillars of Resilience

9.      Conclusion: The Emotional Balance Sheet

Last week, we discussed the core finance principle of risk and return—the idea that the size of returns we get is connected to the amount of risk we take. This week, we take the relationship between return and risk one step farther and ask if human beings correctly evaluate the tradeoff between low risk and high returns (tl;dr – they don’t).

Efficient Markets

One of the prevailing ideas in modern finance is the notion that markets are “efficient.” The efficient markets hypothesis (EMH) posits that market participants quickly incorporate all available information about a potential investment, such that its price accurately reflects the balance between return and risk. Risk and return going together assumes that markets are efficient—that market participants price returns correctly, and that they price risk correctly.

In practice, this is mostly true, but not always true. Many investors spend their careers searching for “bargains”—investment opportunities that can produce higher returns than the market realizes, or investments that are much less risky than they appear to be at first glance. These are typically difficult to find, because people are smart and greedy, and if there is a deal to be found people will find it.

But humans aren’t perfect. Part of the reason that things like stock market crashes happen is that people get carried away with the excitement of rising prices and making money, and they end up ignoring or downplaying risks that they shouldn’t. People able to evaluate risk correctly in that type of environment can make a fortune, because they recognize that an investment that everyone else thinks is a good deal is actually a bad deal. The reverse also happens at the bottom of a stock market crash. Everyone else thinks the world is ending and sells everything, while wise investors buy up lots of stocks that are not nearly as bad as everyone thinks they are.

In other words, they are willing to assume risks—buying stock when it feels like the world is ending—that other people aren’t.

Humans Misprice Risk

This concept maps directly to domains outside of finance, if we treat the word “risk” as a synonym for “fear.”

As we established last week, the relationship between risk and return holds in our personal lives. If the EMH was true, this would mean that doing the things that give us the biggest positive returns in our lives would also be the most dangerous.

But actual physical “danger” and “fear” are not the same thing. Fear is an emotion produced by our nervous system, designed to keep us alive. In prehistoric times, physical threats were everywhere—we are scared of walking alone in the dark because it was very possible to be attacked by a predator, and we feel social anxiety around strangers because 15% of humans were killed by violence before 12,000 BC.

The modern world is nowhere close to this dangerous. 0.0058% of people were killed by homicide in 2021 versus the estimated 15% in Paleolithic times. In most parts of most cities in most countries, it is very unlikely that something bad will happen to you if you walk around alone after dark. Yet the primal fear of these things remains.

What this means is that human beings systematically misprice risk—usually overestimating it. Our minds assign much more “fear” to an action than the true “danger” the action represents. How many people do you know that are afraid to get out on the dance floor before a few drinks? Nearly everyone you know? What is the “risk” there? People are afraid of looking stupid and being laughed at. But how dangerous is that, really? At any given social event, 99% of people are more worried about how you perceive them. Nobody is paying attention to your actions.

There Are Bargains Everywhere

If “danger” is true risk, and “fear” is perceived risk, that means humans overestimate—misprice or miscalculate—true risk across the board. If we accept the principle that return and risk go together, what that means is that there are high return activities that people think are very risky, but they’re actually not. In other words, there are attractive risk/reward trades to be made everywhere.

If you are a person willing to step into fear, and do the things that other people are too scared to do that are not actually dangerous, you are the equivalent of an investor poking around in markets at the bottom of a stock market crash with a huge war chest of money to spend. It’s like buying Citi stock at the all-time low of $10.20 on March 9, 2009 (Citi is now trading at $78.51). If you are the person that can do the thing everyone else is afraid to do (hold on to or buy Citi stock), you are the person that can get a 780% return over 16 years.

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Next week, we’ll talk about the last major risk-related principle in finance, diversification.

Exercise

You can journal on this one, but it’s better discussed with a friend.

1)      Risk Pricing

In what parts of their lives do I see others unwilling to take risks that are not actually dangerous?

In what parts of my life have I been reluctant to take risks, that other people might not consider dangerous?

2)      Risk Tolerance

If discussing with a friend, have the friend answer this question about you.

In what parts of my life do I have high risk tolerance? Where am I willing to do “scary” things that other people are terrified of, but are not a big deal for me?

Another person reflecting on where they feel admiration or envy about our ability to face a fear they wish they could face is an important clue.

3)      Action

Understanding the gap between the market’s estimation of the risk of an action (other people’s fear), and the true danger represented by an action, in what parts of life do I see the biggest mispricings of risk?

If I can confront my fear, where do I stand to gain massive returns in life by buying the stock that nobody else wants to buy?