The assertion “I can handle high-risk investments” is a financial fallacy primarily because it assumes that one’s ability to handle the emotional stress and pressure associated with these investments equates to real, quantifiable success. Markets are unpredictable and even professionals with decades of experience can face massive losses on high-risk investments. Overconfidence can add more risk to your financial profile and might not have the returns to justify that extra risk.
Risk tolerance is highly individual and depends on many factors, including financial goals, age, income level, financial knowledge, etc. Some people may feel they can tolerate high risk because they have a steady income flow or significant savings, or perhaps they’ve seen success stories around high-risk investment. However, it’s essential to remember that these stories are often the exception, not the rule. It’s easy to fall into this overconfidence trap, especially in a bullish market, or when you’ve had some investing success.
An appropriate financial practice is balanced and diversified investing. It involves a mixture of safe and risky investments in proportions that match an individual’s risk tolerance, financial capacity, and investment goals. It includes evaluating each investment not only on its individual merits but also on its contribution to the overall risk of the portfolio. The right behavior also involves continuous education, regular market reviews and adapting your strategy as markets or personal circumstances change.
To grasp a better understanding of this financial fallacy, here are some recommendations for further reading:
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“Fooled by Randomness” by Nassim Nicholas Taleb. Book Link. This book talks about how we often mistake luck for skill, especially in high-risk investments.
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“The Black Swan: The Impact of the Highly Improbable” also by Nassim Nicholas Taleb. Book Link. In this book, Taleb explores highly unexpected events, their massive impact, and our limited ability to predict them.
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“The Psychology of Investing” by John R. Nofsinger. Book Link. This book gives insights on various investor psychological biases including overconfidence.
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“A Random Walk Down Wall Street” by Burton Malkiel. Book Link. The book suggest that markets are largely unpredictable and highlights the importance of diversification and having a long-term plan.
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“Behavioral Finance: Biases, Emotions and Financial Behavior” - Investopedia. This online article can guide you about the cognitive psychological biases that can affect investment and trading decisions.
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“Modern Portfolio Theory” - Wikipedia. This page gives you detailed information on how to balance reward and risk in your investment portfolio.