Perceived Risk and Reward Affects Your Investment Strategy

What’s the most dangerous way of traveling? The first thing that popped up in my mind was flying because of the accidents reported in the news. However, this doesn’t stop us from traveling because the perceived risk of happening something to us is low when we enjoy doing something. Ian Savage revealed that flying is one of the safest options despite our instincts. Below there is a graph.

How effect plays its part Research of Finucane, Alhakami, Slovic and Johnson indicates that how we feel about an activity affects our judgment of perceived risk and reward. The more we like something, the more likely we are to misjudge. This finding implies why many investors prefer an untested stock that seems popular because of the possible upside and less possible downside. Whereas a familiar company with a proven track record is perceived as high risk and high reward.

According to the results, we make decisions not only based on what we think about something but also how we feel about it. This makes it very difficult to make an unbiased decision as an investor about companies.

Investing in a startup or familiar company can both work There is something to say for both cases. There are investors who stumble upon an untested company that becomes a household name, which is a dream for many of us. Few companies start big and you have to begin somewhere. However, a company without a proven record has a smaller margin of safety because of fewer resources to fall back on when things go wrong. You could ask yourself how do you recognize the size of a company? I have learned that market capitalization is an indicator.

The market capitalization of a company is the total number of outstanding shares multiplied with the current market price per share. As a rule of thumb, I have learned to divide companies based on their market cap. This could also help you along the way.

• Small-cap: below 1 billion
• Mid-cap: between 1 and 10 billion
• Large-cap: more than 10 billion

Below there is a graph that divides certain companies on their market capitalization.

At the beginning of my investment journey, I believed that companies with a market capitalization over 10 billion are less likely to grow than smaller companies because of already having a large market share. I learned that the growth prospects of large companies can be limited because they have already benefited from the advantages to grow to their current market cap. These companies are mature and stable businesses who have earned their stripes and weathered difficulties along the way. I perceived the risk of investing in them to be higher than their benefit, which isn’t true.

Seeing how Amazon almost doubled its market capitalization within a year refutes this belief. Their growth is also partly because of the pandemic and therefore receiving more orders than before. This is likely to continue for the time being. Microsoft is another example that increased its market capitalization with over 50% during the pandemic, because of Microsoft Teams, Azure, and a positive outlook on the future.

Takeaway The more we like an activity or a technology, the more likely we judge the risk to be lower than the benefit. This also explains why investors like to invest in unproven companies and focus more on the possible upside instead of the looming downside. Whereas proven companies are perceived as higher risk and higher reward despite their track record. This isn’t only the case while investing, but also in other activities. Driving a car is seen as one of the safest ways of transport, while research shows it’s one of the most dangerous. It’s good to challenge your own beliefs by questioning if they are based on facts or biases.

Thank you for reading and I wish you a nice day.