What do Oprah Winfrey and Warren Buffett have in common?
They are both calculated risk takers.
Oprah Winfrey left her steady job as co-anchor of the six o’clock news in Baltimore to host a third-rate talk show in Chicago. After boosting that show’s ratings to first place, she launched her own show, which became the highest rated program of its kind in history, airing 25 seasons from 1986 to 2011. Her estimated net worth is $3.1 billion.
Warren Buffett, Chairman, CEO and largest shareholder of the investment firm Berkshire Hathaway, is considered the most successful investor in the world. His nickname in investment circles is the “Oracle of Omaha.” Many investors prefer to stay away from stocks that fluctuate in price, believing them to be risky investments. But Buffett views risk and volatility differently: Risk is the possibility of losing your initial investment, while volatility is synonymous with opportunity. Buffett prefers to invest in “value stocks”; that is, stocks that are undervalued relative to their earnings potential. His current net worth is estimated at $67 billion.
The take home message from these success stories is not just that perseverance pays off. It is that successful entrepreneurs are not risk-takers, they are calculated risk-takers. As Winfrey puts it, “one of life’s greatest risks is never daring to risk.” This is the key concept that Leonard C. Green emphasizes in his highly rated entrepreneurial courses at Babson College. It’s no wonder that U.S. News & World Report has ranked Babson as the top college for entrepreneurship 19th years in a row.
So what is the difference between risk-taking and calculated risk-taking?
We make decisions by determining how likely something is to happen and judging the value or utility that the outcome has for us. For example, the chances of winning a million dollars in the lottery are very low, but the payoff is highly desirable. On the other hand, earning interest on your savings is a dead certainty, but the payoff is so small that it hardly registers a blip on your reward radar. The question is why would you go for the long shot?
The results of decision neuroscience research over the past two decades has shown quite clearly that these two aspects of decision-making are handled by separate areas of the brain. We calculate chances using the area of the brain right behind the forehead. When we experience a payoff, evolutionarily older areas deeper in the brain become active, releasing the neurotransmitter dopamine, which travels up to the prefrontal cortex. This dopaminergic “reward circuit” enables our brains to encode and remember the circumstances that led to the pleasure so we can repeat the behavior and go back to the reward in the future. (An excellent two-minute video illustrating the brain’s reward system can be found here.)
Recently, researchers at Stanford University discovered that a particular dopamine receptor (called D2) plays a critical role in risky decision-making. The work was done with rats. Yes, individual rats, too, differ in terms of risk preference. The rats were given a choice of two food levers. The “safe investment” lever released a small but consistent amount of sugar water each time it was pressed. The “risky investment” lever delivered a smaller amount most of the time, but on 25 percent of presses, it released a large quantity of sugar water. Some rats preferred the “risky” lever to the “safe” one, choosing it more than half the time. The other “risk avoidant” rats were strongly influenced by their last choice. If they chose the risky lever and got a tiny payoff, they chose the safe lever the next time.
Here is where it gets really interesting. When the rats chose the risky lever and received a miserly payoff, D2 receptors transmitted a signal, and the signal was much larger in the risk-avoidant rats than in the risk-seeking rates. In other words, risky rats did not receive enough negative feedback from their D2 receptors to allow them to learn to avoid making risky choices. Next, the researchers stimulated the D2 dopamine receptors to boost the negative feedback signal, and voila! Risk-seeking rats instantly turned into risk-avoidant rats. As a last step, the researchers gave the rats a drug that dampens neural responses to loss, and presto! Risk-avoidant rats turned into risk-seeking rats.
Does this apply to humans? The drug that was given to dampen neural responses to loss, known as pramipexole and marketed as Mirapex, is used to treat Parkinson’s disease in humans. The drug is known to increase risky behavior in Parkinson’s patients. We also have known for some time that risk-seekers are characterized by high levels of dopamine, particularly in D2 receptors. Comparisons between identical twins found the trait was 60 percent genetic. Further studies discovered a specific dopamine-producing gene associated with the sensation-seeking personality. In a 2013 study, researchers at University College in London administered a placebo or a drug similar to pramipexole, known as cabergoline, to risk-seeking and risk-averse participants who took part in a gambling task. They found that when taking cabergoline, normally risk-averse participants became more risk-seeking. The drug had little impact on normally risk-seeking participants, because they already showed high levels of risky choices.
Does this mean that people can’t change the way they make decisions — that someone is either risk-seeking or risk-averse? Numerous research studies say that isn’t the case. We can change our approach to decision-making.
The key lies in appreciating that the brain’s reward circuit becomes active when we expect a payoff as well as when we actually experience the payoff. When people decide to make risky decisions, these midbrain areas become highly active just prior to making the decision. In other words, they are experiencing the pleasure of anticipated large payoffs and are not thinking about probability of those payoffs.
Studies like these show that emotion plays a large part in risk-seeking and risk-averse choices. In the world of finance, unregulated emotion causes investors to make less money from their financial opportunities than they can or should. The problem is that rather than focusing on fundamental indicators, risk-takers focus too strongly on the pleasure they anticipate from expected gains, and risk-avoiders focus too strongly on the pain they anticipate from possible losses. To be an effective financial decision-maker, we want to find that “sweet spot” between too much risk-taking and too little.
Here’s how calculated risk-takers do it.
Calculated risky business
Common sense tells us that financial decisions dominated by emotion are often bad ones, and research confirms this bit of wisdom — but with a twist. It isn’t the emotional charge that’s the problem. It’s that we don’t accept our emotions as sources of information that can be differentiated, appraised and used.
The key insight is that emotions enhance or hamper decision-making performance depending on whether or not we first identify the nature of the emotion we are experiencing and then regulate them efficiently.
You would think that people who habitually suppress their emotions would be more risk-seeking than risk-averse, but you would be wrong. Research has shown that people who suppress emotion do not reduce risk-aversion, because it is an ineffective way of regulating negative emotions. In contrast, cognitive reappraisers, who change a situation’s meaning in a way that alters its emotional impact, increase their risk-taking in ways that improve financial outcomes.
In one experiment, 100 participants first completed a battery of tests aimed at assessing their tendency to reappraise or suppress emotions and their tendency to be risk-seeking or risk-averse. They then participated in a repeated stock-trading game. After observing the stock’s first price change, they decided whether to hold or sell the stock and then received a trend update. A number of physiological measures were taken of their emotional states, including heart rate and skin conductance. Cognitive reappraisers experienced lower emotional arousal compared to suppressors, particularly after experiencing a loss. They also made choices that increased the number of investment decisions that maximized their gains. On the basis of these results, the researchers concluded that cognitive reappraisal of negative emotion is not only feasible, it is a strategy that private investors and professional should be trained to practice.
In fact, this is what the best entrepreneurs do. To manage the emotional ups and downs that can result from gains and losses, they seek ways to reduce the risk of loss at each step of the decision process. Forbes contributor Paul Brown refers to this as the Act-Learn-Build-Repeat model. Oprah Winfrey puts it this way: “I believe that one of life’s greatest risks is never daring to risk… Do the one thing you think you cannot do. Fail at it. Try again. Do better the second time.”
To be an effective financial decision-maker, you need to take calculated risks. And that means asking yourself each step of the way how you can minimize losses and cognitive reappraising your negative reactions when losses happen.