Risk

If I cannot remember the past, I call it a memory fault.  If I cannot predict the future, I call it risk.  Risk is a more complicated idea but with a little effort I can understand it and to some extent I can understand what to do about it.

The future is unknown.  Period.

Some things are more predictable than others because the possible options arising from a given activity are more limited.  Like the value of a government bond.  Many people see bonds as certain value.  Perhaps true at maturity but the value in the interim is unpredictable.  Worse there is really no guarantee you will get the money at maturity.  Just a high probability.  When you think about it, the only guarantee you have is the most you will get back.

Some things have a wider range of possibility.  Like how long will you live, how healthy will you be, how much will goods cost in future.  In these situations you have choices.  If you accept the unknown future, then the future will be like looking into a funnel from the narrow end.  The range of possible outcomes is much larger as you look further into the future.  You can narrow that by revising your tactics as you pass along the time line.

Some risks though do not adjust with time.  Death or a car crash or a burning home for example.  Risks like this, that have catastrophic consequences should usually be insured.

Risks break into two groups.  Things that are catastrophic if they occur and are non-reversible and things that vary but tend toward some average answer, like the stock market.

You assess your relationship with risk along three parameters.

  • How exposed are you, (e.g. business owners versus government employees, smokers versus non-smokers)
  • How capable are you of coping with a loss, (Bill Gates could sustain a larger loss than I can without affecting the next meal he eats.)
  • How tolerant are you of the idea of having things work out wrong.  (Some people cannot stand the idea of not knowing what will happen)

People come with a built in bias towards certainty.  They forget that risk is merely the name for the unknown future.  Sometimes the unknown turns out to be good.  Almost no one understand the idea “risk of something good.”  There is a risk that I might win the lottery.

Financial success can be badly affected by poor risk management.  The risk intolerant accept returns on investment that are far too low.  The ambitious risk accepting usually save insurance premiums and get too involved before they start to understand the real situation.  The biggest losers are the ones that try to nurse bad situations back to breakeven.

Understanding risk and what you should do about it is a common sense thing.  If you cannot afford the loss, pay someone else to take the risk.  Insure.  If the tendency is to get what you need far in the future, like the stock market, looking at your portfolio every day will trouble you greatly and to no advantage.  If you cannot tolerate the idea of risk, you might try to be more objective.  Most of the bad things we expect do not happen, but we remember all of the bad ones and forget the ones that worked out.

Managing risk is about ruthless objectivity.

Contact: don@moneyfyi.com  

Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

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