moneyFYI
Financial Freedom Is Merely Organized Common Sense
Risk, Risk Taking, and Risk Management
We all like certainty, or at least predictability. Risk is the fuzzy area between certain to happen and all other possibilities. We must learn to accept that difference and manage ourselves to compensate for the unknowable.
Risk
Risk arises because the past cannot tell us everything we might like to know about how the future will unfold. We forget that numbers, patterns, and conceptual understanding are only tools. Like other tools they do not apply to every situation.
Risk is how much the future varies from our expectation.
There are two ways to make decisions in this situation and survive, at least mentally.
- Deal only with situations where there are very few variations available. You have that choice. For example term deposits from a sound bank, or a government bond, have almost no expectable variation. They give up yield though. No one sane person or entitiy provides value without compensation. In essence you pay a price to remove the risk. It is like paying an insurance premium. Another way to eliminate or minimize risk.
- Include risk of variance in your expectations. If you believe your expectations will follow with 100% certainty, you are being naive.
“Our knowlege comes trailing clouds of vagueness.” -Kenneth Arrow
Understandng how the future is a variable and how you have choices about dealing with that is fundamental to risk taking.
Risk taking
Risk taking a necessity as we must live the rest of our lives in the future. We have come to accept most of it without thinking about it. Crossing a busy street. Riding a horse. Driving to the airport. Eating in a new restaurant. People accept far more risk than they think.
Other decisions are made after risk is considered. In these cases, we base our decision on quantifying the past and extending it to the future. To that we add subjective issues. Eventually the decision becomes better than a guess, but not quite up to determinative. Things will happen we did not expect and we will be surprised and often unhappy. We seem to take happy surprises as unworthy of consideration in a risk discussion.
If you look at people making these decisions you see a method. Starting a business, buying an investment, choosing a life partner, deciding to have children, picking a university course, changing jobs, or buying a house are examples where people actually think about their choice.
Risk management
Risk management comes in two parts:
- Pre-decision. We Take what we know, what variables we can isolate, and what we can find about what others know. We can then project how the future should unfold given what we have thought about. If we are very careful we might build a matrix of outcomes based on changing variables like yield, inflation, tax rates and such. For very long futures, like investment portfolio performances, we can use Monte Carlo techniques. Monte Carlo might test 10,000 projections and see where they cluster. Essentially how things are likely to work out. They also provide ideas about what good and bad things could happen. That allows you to assess what you should do about those.Always include an assessment of the adverse case. Like a trial lawyer preparing his opponent’s case so they can see weaknesses and strengths objectively.
Proto-decisions fit here. Easily changed decisions intended to help you get more information about the nature of problem environment. - Post-decision. Decisions that can be varied after implementation are less risky than those that cannot. Having a child is much riskier than buying a green car. Sound risk management includes understanding how someone could change as things progress and more useful information comes available.
Sound risk management includes building in some change options into the decision so they are available later. For example, if you own a building on a corner lot, should you buy a building adjoing yours so you have the ability to expand? In the beginning you don’t know if you will ever need those properties and they come with a price and costs to keep. The risk control decision involves paying a premium to have the choice. An option to buy is the solution. Pay a little until you know the future situation.
Insurance of all forms is an option on some future conditional event. Insurance is a well-developed tool for dealing with specific risks.
Other choices include dealing with more than one supplier of a critical resource. If one is on strike, you still have supply. Training people so they can cover more than one duty is powerful. Periodically shopping for banking, employee benefits, and other overhead items helps.
People who spend time on educating themselves do better. Education allows you to do pre-decision risk management better and it helps you find better ways to change after the future intrudes on your plan.
The takeaway
Risk taking is how we address the future.
Risk management is how we attempt to optimize the future.
Better preparation, planning, improves the expectation that the outcome will conform to your expectation.
Recognize the errors occuring in the future are merely the inability to conform to your particular expectations. Learn to manage your expectations better. The book “Thinking in Bets” by Annie Duke provides some insight into the idea. The future is uncertain and some very rare things can and will occur. Learn to build better processes when they do, not assume a bad outcome means a bad decision. You can make good decisions and still get bad outcomes. I suppose you can make bad decisions and get good outcomes too. Learn to distinguish outcomes form decision processes.
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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