Risk Is A Poorly Understood Problem

People have a peculiar approach to risk. It is because they don’t define it very well.

Risk is about uncertainty. It is not a thing by itself. Uncertainty involves things turning out worse than we hope, it can also mean things are better. “We have had some business reversals, things are good now.” The key idea in uncertainty is it depends on two things. Expectations and how they match future outcomes.

Risk is therefore unavoidable. Our ability to create expectations to play out in the future is flawed. We are not especially good at defining realistic possible outcomes and the future always contains surprises not considered in our expectations.

The uncertain outcome can be of three kinds.

  1. The outcome is transitory and is likely to go away if you wait. Like the stock market. This sort of uncertainty is the result of a marketplace that includes far more input than just the value expected. Expectations of others influence the prices, personal priorities, misinterpretation of news, potential government action or competition, or changing economy. The loss will only become real if the person closes their position at a loss. This kind of risk requires two events to occur. The price moves and the person crystallizes their position at a loss.
  2. The outcome is complete. A single factor risk. Often catastrophic. Like a person dies, or is disabled, or loses a particular job.
  3. The outcome appears complete but with action and resources could be reversed. The action required is a second factor.

You handle two factor problems differently from one factor problems

The fabric of the risk matters

It can help to organize your thinking around certain risk ideas:

  1. Probability of occurence
  2. Cost or benefit of having it occur.

There turn out to be four possible conditions

  • Low probability – high cost
  • Low probability – low cost
  • High probability – high cost
  • High probability – low cost

Once we define risk as the level of uncertainty about how our expectations will play out in the future, we can begin to assess ways to minimize or manage the events that occur.

Understanding the risk prior to managing it

Both loss and probability are relative factors. Each of us has our own idea about the meaning to attach to each.

Cost of the loss is a big factor. If the cost is low, maybe we could ignore the risk. How much risk should you be willing to absorb rather than pay or use other resources to make it go away. It is about what your other resources are and how you feel about bad things happening. That’s capacity and tolerance. Question: Bill Gates house is worth something around $120 million. Should he insure it for a fire loss. The house represents about 0.1% of his net worth. The question would resolve based on his approach to loss not his need for the money.

Cost is relative. The question is not the dollar amount of the loss it is its relative place in our net worth. A homeless person who loses a $10 bill may see it as a serious issue. The Gates’ home is within the the round off on his net worth.

We see probability as a meaningful factor. If the loss is small we may not care about the probability. If the loss is large we do care.

Understand probability in context. You might decide what you mean by large probability of loss. It will depend on the value of the loss. If someone says there is a one in a thousand chance my bike will be stolen, I will not alter my life much to avoid the possibility. If they tell me the next time I answer my phone, there is a one in a thousand chance the phone will kill me, I will never answer the phone again.

How do we manage risk?

If the risk is large and the probability of loss is also large, we must find ways to avoid it. Suppose I am in the habit of selling goods in Dubai and I deliver them by sea. Efficient, price effective, and easy. Suppose there is a serious military conflict in the gulf and now the delivery is highly likely to be destroyed. Along with the ship it’s on. The only defense is to find another way to get the goods to Dubai. Perhaps ship to Cairo and overland from there. Maybe not ship at all.

In simple terms deal with exposure to the risk. Possible loss and likelihood of seeing the loss. Avoidance is a key management variable then.

Consider exposure, tolerance, and capacity.

Avoidance has a price. Sometimes it costs more to avoid the risk than the cost of a loss is worth.

At the other end of the spectrum we have low cost and high probability. Accept these risks and when they occur, they are at most inconvenient. You lost your umbrella and it is raining. You left a paperback book on a train. You spilled mustard on a t-shirt. You misplaced your favourite pen. You cannot avoid everything unless you are willing to pay a high price to do so.

Risk avoidance should have an expected value that is positive. The sum of all these losses, once incurred, must be less than the cost to avoid them. Think about department stores. How much would shoplifting have to cost them before they paid the price for security?

Other management techniques exist.

These usually involve not avoidance but reducing the probability of occurence.

Would you store a can of gasoline beside the fireplace? Probably not. Do you brush and floss your teeth? Do you exercise, avoid drinking and driving, avoid street drugs? You already do things that are aimed at reducing the probability of a bad thing happening. The one I like is, “Do you make an effort to control your weight?” Someone told me that life is perfectly fair in this respect. The more extra weight you carry around, the less time you need to do so. Motivation. New Year’s resolutions are coming up.

Insurance is a powerful risk management tool. It deals with low probability risks that have a cost we cannot afford.

More tomorrow.

I help people understand and manage risk and other financial issues. To help them achieve and exceed their goals, I use tax efficiencies and design advantages. The result: more security, more efficient income, larger and more liquid estates.

Please be in touch if I can help you. don@moneyfyi.com 705-927-4770

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