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Mark's Market Blog

The Utility of Money

By Mark Lawrence

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We all have an intuitive notion of risk - jumping off a cliff with a parasail is a good example. In investment theory, risk has a particular mathematical meaning. So, when you're talking in everyday conversation you can keep your old definition of risk. If you want to learn investment theory you're going to have to accept a new definition for this field.

We'll start with a simple made-up system. Suppose you have

Your tolerance for risk should also depend on your future expectations for making money. For example, a student at Yale Law School or Harvard Medical School expects that in a few years they will be making a lot of money, so signing up for massive student loans is considered a good risk. More to the point, your basic investment strategy should depend on your future expectations for making money and needing money. Someone in their 20s can afford to use a more risky approach to investing their money. If they lose a bunch of money, they have 30 or more years until retirement to make it up, and if they make a bunch of money, after 30 years of compound growth the payoff will be very large. If you are in your 40s and making a large salary perhaps you would choose an investment strategy with greater risk and greater potential payoff, again on the theory that you have some time to make up losses. If you're in your 60s and have only a marginal retirement account, you would be best served by a low risk low return strategy, as you have little time to make up losses. If you have a sudden one- time gain, perhaps due to an inheritance or winning the lottery, again you would be best served by a low risk low return strategy, as you have little chance of making up large losses.