I think about risk often.
After all, that is my business. What will change a life outcome adversely and what should someone do about that? It occurred to me recently that it would help to understand risk better.
What do we mean by risk?
It turns out there are several definitions:
Merriam Webster –
possibility of loss or injury
someone or something that creates or suggests a hazard
the chance that an investment (such as a stock or commodity) will lose value
- At Risk – in a state or condition marked by a high level of risk or susceptibility
Mathematical or Engineering
The amount of a possible loss multiplied by its probability of occurring.
We learn two things.
Risk is about probability and risk means loss.
Neither is very helpful. Risk of loss is fear inducing and that clouds judgement. Probability is unknown in respect to the future and that attenuates fear. Therefore, risk is bad.
In fairness to risk, there is a risk that things might get better. No one addresses it that way, but it exists as a possibility.
Another way to think about risk.
Suppose we think about risk as part of the recipe for thinking about the future. The future is unknowable and risk tells us that. When we see unknowability we see fear and call it risk.
Insurance is interesting because there is no do over if you get it wrong. That decision is much easier. You buy coverage and hope you don’t need it.
Investment risk in the traditional way of thinking is about volatility and it is quite different. Is that a good way to think about risk?
It has attractive parts. It is measurable. You can calculate with it and gather outcomes that may or may not have meaning. The only rational meaning you can find is risk has little to do with permanent loss of capital and much to do about how we humans think, or perhaps feel. Risk really asks this question:
Given how I feel about measurable paper losses and gains and given how much of each I could see with the security I am considering, is the potential return worth my psychic investment over time?
Emotional investors would prefer less volatility and will perhaps accept lower returns to avoid the future emotional turmoil. Perfectly reasonable. There is a price for every comfort.
The cure for risk is within us
It has little to do with the securities themselves and a great deal to do with how we assess their performance. It is relative not absolute. It is like managing a relationship. If I go golfing with my friends and tell my wife I will be home at 8, I will be well received if I appear at 7:30. If I had told her 6 and arrive at 7:30, the response may be different. Same outcome, different emotional return.
Highly volatile results are troubling even if the volatility averages out to be the expected return.
Perhaps we should accept the fact that you, I and every other human cannot predict the future with any accuracy. We can follow historic ideas and we can accept fluctuations once we know the future is unknowable. The numbers may confuse us, but the ideas are simple.
Maybe this will help.
“Risk means more things can happen than will happen”
Elroy Dimson, London Business School
It is about our choosing ways that may not happen or choosing ways that do happen, but differently than we expected.
Every difference from expectation is the result of two possible things.
- It is a random fluctuation
- It occurred because of a factor we did not consider in our original thinking.
If it is random, it will possibly reverse. If it is a thinking flaw, we learned something.
Like comfort, education has a price.
You can best control your stock losses by asking a simple question. Given the current price, should I buy more or sell? Hold is just lazy thinking.
Think of it as choosing between the money and the security. Whether you give up money to get the security or give up the security for money, the analysis is the same. What future looks better? Money or stock. Only the order of events is different.
Use rational thought to try and keep fear and greed at bay.
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. email@example.com 866-285-7772