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Financial Freedom Is Merely Organized Common Sense
What Do We Know About Risk?
The dictionary defines risk as a situation involving exposure to danger.
When you think about that, you find it is about the future. Exposure to danger is only the possibility that sometime in the future something adverse will happen. There is not risk in the past nor in the present.
Since the future is always there and it is always unknowable with precision, there is always risk.
An observation
Nick Murray makes a useful point, “There is no such thing as no risk. There’s only the choice of what to risk, and when to risk it.”
There is also the ability to manage the situation once the choice has been made. Choices that provide many options are inherently less risky than those that are once and done.
Managing risk involves understanding the risk
There are two kinds of risk.
Risk that depends on time alone. Like the stock market. There must be some action to make the risk costly. If you buy a stock, say Coca Cola in 1918 at $40.00, you would have found it at $20 just a year later. You may have known the risk in the beginning and it really was there, but there is no money cost to you until you sell your position. If it was a viable business in 1918, it likely was in 1919. Keeping it would not change the risk involved in 1920 and following, but you have no loss until you sell.
If you keep it, your position in 1918 and 1919 is the same. You own x shares of Coca Cola.
Many people think of the market price defining their loss or profit. It is for reference only. You can’t lose money untill you sell. The stock is not money, it is piece of a business. You gave up money the day you bought and you can get money back the day you sell. In between the stock is not money.
All stock market risk is transient. It depends on when you need the money. Learn about how the market works and how the business fundamental value works. You will soon discover that the two come together only rarely. They are different ideas of value.
Risk that depends on some event happening. Like a car accident, illness, or perhaps a home fire. If it happens it is done and will not recover over time. You mange these risks differently. You consider several factors and try to mange those.
- Exposure: You can manage the probability of the event occuring. Don’t store gasoline in the basement for example. Exercise, eat right, reduce stress. Don’t drive recklessly.
- Vulnerability. Capacity to withstand the loss. Bill Gates house is worth in excess of $100 million. He would not be affected financially if it burned to the ground. I would be. Some people are more vulnerable to the effects of the catastrophe than others. Like with Covid. If you are over 60, diabetic, overweight, in poor physical shape, have type A blood, and travel, you are more likely to be badly affected than many of the others. Again, you manage the factor not the event itself.
- Ability to hedge the risk. If you can pay someone else to hold the risk for you, you may have the consequence but not the effect. That’s what insurance is about. Letting someone else absorb the financial consequences of the potential event. There are four general conditions. Only one of them is worth insuring.
- High probability Low cost. Self insure.
- High Probability – High Cost. No one will insure that kind of risk
- Low probability – Low cost . Self insure.
- Low probability – High cost, Valuable insurance. If you can’t afford the loss, pay someone else to take the financial risk. Because the rpobability is low, the premium will not be high in relation to the potential loss.
The difference
Essentially when and what you manage. With investments, the risk and its potential cost is in time and your understanding of business value versus the market price.. A process. With event type risk, it is in the occurence. On or off. Happened or didn’t.
The nature of each is different and you must manage the risks differently. Learn how.
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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