Why Does Risk Aversion Differ?

One of my coworkers very recently moved to this state from across the country. In doing so, he had to pick up his family, sell his house and buy a new one all while working remotely, traveling back and forth and transitioning to a new area (and climate). We got to talking about real estate and what he was looking for when he bought his house and some of his answers were quite revealing. He bought his house in cash due to a strong preference from his wife. This revealed two things to me:

  • As a single man, I haven’t had to experience the push and pull between risk tolerance of a couple
  • I have a much higher tolerance for debt than most

Why is he afraid of debt?

When I pushed on the topic a little bit, I came to recognize he had not thought of the tradeoff too closely. He is rather young so he has quite a few years until retirement and could use the debt to invest more in a nest egg. Asking how long he wants to work, he answered ‘forever’, which, while different from my own, should imply that he has a higher risk tolerance than myself. Paying a house in cash is something that I believe I will never want to do. The power of leverage tied with my age means I will always be getting a mortgage to amp up the amount of assets my equity will be able to buy.

This issue manifests itself in the PF world as well. I’m sure we at DQYDJ have complained about debt aversion in the blogosphere quite enough and have been told that a lot of the explanations are psychological and security. A Dave Ramsey acolyte will preach that debt is a plague or a disease that bears down on you that you need to fight off. I have a different opinion. I’m a little upset that I can’t get more debt. My debt burden is too low. At my age I should be seeking as much debt as possible (tied to appreciating assets) so that I can use my youth as an advantage. With the money I would pay down my mortgage, I would just as soon buy another house with another mortgage.

A man who understands leverage

A man who understands leverage

Why am I so comfortable?

This is a question where I struggle. Part of my debt tolerance is due to my age. Being young and in a career where I feel potential for income gains is significant means focusing on reducing debt (VERY different from reducing expenses, please note the difference) is not the best use of my money. Acquiring assets and using the power of time is something that you can never gain back. If you’ve been reading some of my series, you have recognized this mentality has manifested itself in my preference for adjustable rate mortgages (and adjustable rate energy prices, mind you). Hell, I’d get an adjustable rate auto loan if they were offered.

Another part of where I am comfortable is that I am single. Without somebody else to take care of or recognizing I have a family dependent on me, my actions are surely different. My coworker who said he wants to work forever may always have that desire, but he may not always have the means. Injuries and health issues crop up without asking for them. Perhaps it is a sign of my immaturity that I cannot see myself relinquishing control of my risk tolerance to somebody else, but for now I will continue to seek as much debt and leverage as possible. Unfortunately, my leverage has dropped from about 7:1 to 5:1 in the past few months.

Cheers,

Cameron Daniels

P.S.  For some good reading on investment decisions in relationships, read my coworker’s article.

Comments

  1. says

    I’m guessing I’m not as young as you, but I agree with you about debt. I wish I could borrow $10,000,000. Then my investing strategies would NET me over $10k per week (without even trying) above and beyond the cost of maintaining 10-million in debt.

  2. says

    I’ll take the contrarian view. We’re completely debt free. However, I’d still categorize myself as risk-seeking. I’ve started several companies and actually sold one. I went for 18 months without a paycheck while running the company I eventually sold. Being debt free provided us with real options, including the choice and ability to live on one paycheck while I got the company off the ground and running. Had we been carrying debt (even rental property debt, as those vacancies and roof repairs can come at inconvenient times), then I probably would have felt the need to get a jobby job to make absolutely certain that we could pay the bills. While debt used in pursuance of investments (as hungry hungry artist alluded to) provides you *financial* flexibility, it comes at the cost of income flexibility, as you have to dedicate a portion of your income – regardless of the source – to debt service.

    Here’s another benefit of the no-debt approach: in investment real estate, I only go after property or property owners that are distressed in some manner. It creates pricing inefficiencies that I can take advantage of. I make offers as all cash, close in 7 days, and they have to respond within 24 hours or I walk. I can get a discount at the purchase because the seller doesn’t have to deal with financing risk.

    So, I simply put my risk in other areas. Some put it in financing. I put it in income generation.

  3. Jason R says

    Be careful not to confuse the capability to take risk and the need to take risk. Your coworker may have the capability to add risk, but why would he if he’s already won the game by his definition? Perhaps he really enjoys his job, is on a life-path he really enjoys with enough buffer saved for downside protection, and doesn’t see much benefit from increased material consumption. In this scenario, the added risk of leverage may not lead to any relative benefit and therefore his risk-adjusted reward for the leverage would be negative.

    • CameronDaniels says

      I agree. He has a different risk tolerance and goals in his professional life so I can’t presume to make him take on more risk. It just made me wonder about myself and what would make me more risk seeking.

  4. freeby50 says

    I think there are a couple things that impact peoples risk aversion.

    First of all I think some people are simply naturally risk takers. Maybe you’re born that way or maybe its part of how you’re raised. I’m not sure but I think some people just like risk more. I mean some of us like racing motorcycles and skydiving and some of us don’t. Risk and debt are related. If you’re OK with more risk then you’ll be less averse to debt and if you’re wary of risks more than you’ll be more debt averse.

    Second, I think it depends on your experiences. If you grew up in a home with low income and high debt where creditors hounded your parents and your home was lost to foreclosure then you’ll likely grow up to be an adult who has gained a high aversion to debt. If you never experience any downsides of debt in your life then you’ll likely not fear debt much.

    • CameronDaniels says

      I think I would agree with the first point. People are natural risk takers whether that be financial or personal life.

      Not sure I agree on the second point, I can see the case where using debt to finance every purchase is passed on from generation to generation as well as those who are afraid of debt teaching their children the same.

      • freeby50 says

        People can follow in their parents bad example or learn from their mistakes. I’ve seen it go either direction. But your experiences growing up and otherwise can certainly contribute to your attitudes about finances, good or bad.

  5. says

    Interesting post.

    In addition to personality factors, it surely depends on your age, whether you have children, and what you hope to accomplish financially. It also depends, I think, on how well you understand the tendency of the market to cycle — or the nature of other products in which you decide to invest.

    • CameronDaniels says

      Would you say there is more risk tolerance if you recognize that markets fluctuate? I would consider myself having a very high risk tolerance with the explicit assumption that there will be highs and lows. I would think that those who do not recognize this will be scared off by the inherent volatility of the market.

  6. Louis Mack says

    In regards to risk aversion, I still find the psychological angle very interesting. I believe much of this has to do with your parents and how you were raised.

    Great article Cameron, thanks!

  7. says

    I think that aversion and fear are two different things. Fear is often irrational, whereas aversion might be rationally reached based on a person’s own calculus of risk / reward given their current and future estimated obligations.

    During the recession we took on as much debt as we could to buy real estate when it was dirt cheap, but we’ve paid everything except our 3.25% mortgage in the last couple of years because getting rid of 5% and 6% interest rates felt like a nice guaranteed return when we didn’t see obvious value propositions elsewhere.

    Should nice investment opportunities come up again, we’d have no problem taking on more debt, but it’s got to feel worth it.