The risk is not in our stocks, but in ourselves

Risk exists in another dimension: inside you.

If you want to know what risk really is, go to the nearest bathroom and step up to the mirror. That's risk, gazing back at your from the glass.

If you overestimate how well you really understand an investment, or overstate your ability to ride out a temporary plunge in prices, it doesn't matter what you own or how the market does.
Ultimately, financial risk resides not in what kinds of investments you have, but in what kind of investor you are.

The Nobel-prize-winning psychologist Daniel Kahneman explains two factors that characterize good decisions:

1. Do I understand this investment as well as I think I do? ("Well-calibrated confidence")

2. How will I regret if my analysis turns out to be wrong? ("Correctly-anticipated regret")

To find out whether your confidence is well-calibrated, look in the mirror and ask yourself: "What is the likelihood that my analysis is right?" Think carefully through these questions:

• How much experience do I have? What is my track record with similar decisions in the past?
• What is the typical track record of other people who have tried this in the past?
• If I am buying, someone else is selling. How likely is it that I know something that this other person (or company) does not know?
• If I am selling, someone else is buying. How likely is it that I know something that this other person (or company) does not know?
• Have I calculated how much this investment needs to go up for me to break even after my taxes and costs of trading?

Next, look in the mirror to find out whether you are the kind of person who correctly anticipates your regret. Start by asking: "Do I fully understand the consequences if my analysis turns out to be wrong?" Answer that question by considering these points:

• If I'm right, I could make a lot of money. But what if I'm wrong? Based on the historical performance of similar investments, how much could I lose?
• Do I have other investments that will tide me over if this decision turns out to be wrong? Do I already hold stocks, bonds, or funds with a proven record of going up when the kind of investment I'm considering goes down? Am I putting too much of my capital at risk with the new investment?
• When I tell myself, "You have a high tolerance for risk," how do I know? Have I ever lost a lot of money on an investment? How did it feel? Did I buy more, or did I bail out?
• Am I relying on my willpower alone to prevent me from panicking at the wrong time? Or have I controlled my own behaviour in advance by deversifying, signing an investment contract, and dollar-cost averaging?

"Risk is brewed from an equal dose of two ingredients - probabilities and consequences."

Before you invest, you must ensure that you have realistically assessed

• your probability of being right and
• how you will react to the consequences of being wrong.