The Risk-Wealth Paradox

Why More Money Means You Should Take Less Risk

There’s a common belief that as your wealth increases, your capacity to take risk increases as well. After all, when you have more you can afford to lose more, right?

This might be correct in the extremes, but this argument doesn’t hold in more typical wealth ranges. Why?

Because a dollar isn’t always a dollar. And once you understand this, you’ll never look at risk-taking the same again.

A Dollar is Not a Dollar

In the real world, people don’t treat every dollar the same. As I discussed in The Wealth Ladder, your first $10,000 is more impactful than your next $10,000. It’s also true that your first $1M is more impactful than your next $1M. And so forth.

The reasoning for this is two-fold. First, every step up The Wealth Ladder creates a sort of lifestyle floor that people don’t want to go below. For example, once you know what it’s like to not worry about grocery prices, you don’t want to go back to a world where you do.

Second, the more wealth you have, the more wealth you require for a large lifestyle change. Going from taking a bus/train to taking a plane might cost 1.5x-2x more depending on where you’re traveling. But going from flying first class to flying private will cost 10x more. It’s these exponential increases in cost for marginal increases in convenience that creates this step-like structure for wealth.

As a result, it becomes optimal to de-risk as your net worth increases. So while you can take more risk as you get richer, it doesn’t mean that you should.

Of course, the risks you take will always be relative to your desires. If you won’t be satisfied until you’re flying private in Level 5 ($10M-$100M), then you have to keep taking big risks. But, if you’re content flying commercial in Level 4 ($1M-$10M), you can dial it back much sooner.

As your wealth changes relative to your desires, your capacity to take risk will change with it. The closer you are to being fully content, the less risk you should want to take. I call this the Risk-Wealth Paradox.

The Risk-Wealth Paradox

The Risk-Wealth Paradox goes against the economic theory on risk appetites. Standard economic theory suggests that as our wealth grows, our absolute capacity for risk increases. As we build wealth, we can lose more and still survive.

But the Risk-Wealth Paradox suggests that the rational choice is the opposite—as wealth grows, risk-taking behavior should collapse. This is true because while the financial cost of a loss goes down with more wealth, the psychological cost goes up.

I’ve previously discussed how your appetite for risk should decline in middle age as your liabilities increase (e.g., children, aging parents, etc.). I would apply the same line of thinking to those who have built some wealth. As your net worth increases, preservation becomes more important than chasing increasingly expensive luxuries.

Why is this the case? Because once you’ve won the game, the value of gaining a dollar plummets while the pain of losing a dollar soars. This is the fundamental principle behind prospect theory. Prospect theory states that people react to gains and losses asymmetrically. In other words, the pain of losing $100 is larger than the pleasure of winning $100, at least for most people.

And when you’re wealthier, it’s like prospect theory on steroids. If you had a $2M net worth, the pain of losing $1M is significantly larger than the pleasure of gaining an additional $1M. It might even be larger than the pleasure of gaining $4M. While these amounts are arbitrary (and will vary from person to person), they exemplify the impact that wealth can have on risk-taking.

The other reason for the risk-wealth paradox is the amount of time it takes to recover from a significant loss. If someone with $1,000 in a brokerage account lost it all, they could likely earn it back relatively quickly. But if someone lost $100,000 in their retirement account, it could take years to save that amount of money.

Unless your income can keep up with your wealth over time, you’ll have to decrease how much risk you take. Why? Because as your portfolio grows it becomes harder to replace future losses with future earnings. If you can save $50,000 a year, you can replace a 20% loss on a $1M portfolio in under 4 years (assuming a 5% return on your money). However, to replace a 20% loss on a $5M portfolio it would take over 14 years!

This divergence is what contributes to what I call the risk squeeze.

The Risk Squeeze

Your ability to take risk throughout your financial life will be influenced by three primary factors—your age, your liabilities, and your level of wealth. As each increases, you should naturally want to take less risk. Unfortunately, these tend to all move up in middle-age. Does this mean we should be holding 100% Treasury bills when we are in our 40s?

Of course not, but you have to consider how your risk taking should change over time. When I started invested I had 15% in U.S. bonds. Then I was 0% U.S. bonds for a few years. And now I’m 20% U.S. bonds with a growing amount of Treasury bills and tax-free munis on the side (for an eventual home purchase).

Is this right? I have no clue. But it allows me to sleep at night. I’ve been fortunate to build some wealth and I also now have a family I’ll need to support in the future.

The risk squeeze is upon me and I’ve already taken steps to reduce my risk accordingly. I’m no longer playing to win. I’m playing to not lose.

What about you? Where are you in your financial journey? Is the risk squeeze upon you?

It’s easy to critique someone else’s risk-taking, but far harder to be honest about your own. I can’t tell you how much risk to take. But if you’ve won the game, stop playing.

Thank you for reading!

This article was originally published at: https://ofdollarsanddata.com/the-risk-wealth-paradox/