According to Merriam-Webster’s dictionary risk is, the chance that an investment (such as a stock or commodity) will lose value.  This definition erroneously assumes that not investing precludes such risk of loss, but of course cash in a safety deposit box takes on the risk of inflation (e.g. the risk of the declining purchasing power of the currency in which that “cash” is held) as well as storage costs.  Even cash invested into so-called, riskless savings instruments such as U.S. Treasuries takes on a similar though admittedly less severe form of inflation risk, namely, the risk that the real rate of return of the savings instrument will be negative after accounting for the shrinking purchasing power of the currency in which that security is held (as well as the admittedly low probability of issuer default).

Almost everyone recognizes the realities of such risks and therefore chooses to accept more aggressive investment risks in order to generate a rate of return that will exceed the inflation rate risk.  This takes us into the realm of risk-seeking investments such as equities, commodities, derivatives, and alternative investment vehicles (such as hedge funds).  The problem with such risk-seeking investment vehicles is that if the investor/trader is too aggressive they can lose all of their money.  This is known as the risk of ruin and it is the primary reason that investors seek the relative safety of risk-averse investment vehicles such as the aforementioned treasuries. 

Now that I’ve outlined the basic parameters of risk as it pertains to investing, I’ll examine the four basic emotional responses regarding risk (and the potential for loss), namely: paralysis, aversion, recklessness and prudent risk seeking (or what I call, risking courageousness). 

Cash in a safety deposit box is the risk avoidant savings (as opposed to investing) strategy that I map to the emotional response of paralysis when faced with the possibility of loss.  Being paralyzed by risk is a “freeze” response to danger (e.g. fear of loss) and risk of ruin is a real danger in the investment realm. As opposed to the “freeze” response to the risk of ruin, the other common emotional responses are fight or flight.  The “flight” response is easily mapped to risk averse investments such as treasuries.  Our risk averse investor recognizes that freezing is a suboptimal emotional response to the risk of loss and so takes action in the least “risky” way possible, even if it means a negative real rate of return. 

The other possible emotional response to danger (fear of loss) is the “fight” response.  The potential problem with this response to risk is recklessness or the pursuit of an investment “strategy” with a high probability of the risk of ruin.  The more common term for this emotional response to risk is gambling or the pursuit of a strategy without a discernible edge and / or without prudent rules for mitigating the risk of ruin.  In fact, the main argument in favor of the risk averse investment response is the fallacy that the only alternatives are gambling or cash in a safety deposit box.

However, an alternative to recklessness as a risk-seeking fight response to danger is the pursuit of a positive expectancy investment strategy which leans into risk while minimizing the risk of ruin[1].  These strategies include trading or investing in equities, commodities, derivatives as well investing in non-traditional vehicles (such as hedge funds).  When we pursue risk-seeking investment strategies with a statistical edge while applying prudent rules for managing the risk of ruin (including stop losses, per position loss thresholds, per asset class loss thresholds and other diversification tools), we are employing a risk-seeking strategy without the earmarks of gambling.  In other words, we are courageously facing into risk (fight response) without falling prey to the pitfall of emotional recklessness.  This is what I call, risking courageousness and I contend it is the only emotionally healthy response to the problem of coping with risk.

[1] In Trade Like a Casino (Wiley Trading, 2011) the pursuit of a positive expectancy methodology combined with prudent rules of risk management is called, “The Casino Paradigm”.