Warren Buffett has said, “Risk is what happens when you don’t know what you are doing.” If so, then risk is relative. Knowing that can lead us to fruitful ground.
In the simplest way to think about it, risk is a condition of the future and is therefore uncertain. Some risk is harmful should the event occur, while other is incidental and variable while still others can provide a positive event. Most people don’t think about the idea of a positive “risk” but the rules are the same. There is a risk that I could win a lottery or bet the right number at roulette five times in a row.
Risk comes in several forms and people often try to think of them as one thing. Confusion follows.
Mathematically risk is the cost of the event times its probability. These need an event. Like I died, or became disabled, or my house burned down, or I crashed my car. These risks happen or they do not. The probability of them happening is measurable based on historic data. The probability of a 30-year-old, healthy, male non-smoker, dying in the next 15 minutes is about the same as the probability of winning a lottery. Smallish. Because the odds are small and the population of people like this is large, it is possible to buy economical insurance against the problem. Insurance is fundamentally a risk avoidance product.
With investments, risk is variability. Highly variable investments are “risky” because you cannot know the value of your investment at a particular time in the future. Could be high or low. This kind of risk says little about the investment. The risk part is conditional on you. Particularly, when do you want to convert back into cash? It is always good to look at investments and relate them to how variable the investor is. Are they likely to want the cash at an inopportune time? If they never want the money, then the investment has different risk parameters for them.
Risk as predictability can be managed by diversifying investments effectively. Unless you want all the money at the same time. Diversity is a defense against the circumstances of the investor.
Can you control risk? Probably No. Can you manage it? Probably Yes. That is Buffett’s point. Understanding the investment in its marketplace and given your own strengths and weaknesses opens up opportunities to take on risk and to be rewarded for so doing.
Understand your tolerance for risk and notice it changes as you gain experience with losing. It usually starts high. Risk tolerance plus experience is about constant. Choose the risks you need. There is little value to becoming stressed to gain money you have no use for. Richest person in the cemetery has little value.
Understand your capacity to accept risk. For most people losing $5 million would be devastating. Bill Gates would not notice. Do not take risks you cannot afford. Do not take risks you cannot understand.
Understand your exposure to risk. Understand where you are and what the surrounding world is doing, has done and likely will do again. You can minimize your exposure and not by buying guarantees. Guarantees expose you to other risks, like inflation or adverse taxation.
Like most of life, risk acceptance and management is about balance. Risk is unique to you. What you can understand, you can manage. Risk is contextual. Learn the meaning of risk for you.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772