Thinking About Risk

People don’t like risk. Some fear it.

You cannot manage it effectively from that mind place. Learn to understand it a little better.

Risk works both ways. 

There is a risk of loss and a risk of gain.  You should examine both possibilities. There is danger to not recognizing the risk of gain. Some people think risk taking automatically improves the yield. That is obviously not true. If it were true they would not call it risk-taking, but instead it would be “sure thing taking.”

Avoid beliefs that can hurt you until you understand them.

Risk is probabilistic.

There is a “chance” it will happen but not certainty. Knowing the probability is not a complete assessment of risk.

The second part is the value of what might happen. The loss if it happens.

The third is the consequence of the amount.

Suppose you might lose $100,000 with 1% probability

The expected value loss of $1,000 is likely affordable. How about the consequential loss of $100,000. That would be different. How different should affect your actions.

The problem with expected value.

Looking at the two parts. The $1,000 expected value loss assumes there will be an infinite number of iterations and they will work out to that on average. You don’t get the “on average” choice. Your result will be binary. It happened or it did not.

Expected value has no meaning for anyone who cannot play many times, or who cannot withstand the consequences of the loss.

Risk fits into four conditions.

  1. High probability – low cost. Things like dental insurance.  Might be a convenient way to pay. Use deductibles intelligently
  2.  High probability – high cost. Avoid the risk. Refuse to participate. Russian roulette, for example.
  3. Low probability – low cost. – pay the losses when they occur
  4. Low probability – High cost – Insure. The only true insurance.

The risk attached to an unaffordable loss is not so hard to manage. Be smart and minimize the risk. Insure what you can at an affordable cost. Avoid what you can and accept the rest.

Know the cost to eliminate any of the risks you care about. If you don’t eliminate it, you implicitly have accepted it.

On the plus side.

Investment risk is really just variability. If you play long enough, it will even out. The long run return is about 10% before costs.  The key to having it even out is not having to quit.

Emotion is one aspect. Fear is a poor counsellor.

Financially is different. Volatility has a time component to go with size, probability, and consequence. Your additional defence to that time element is liquidity outside the portfolio. If you need money and can get it it without selling assets at a bad time, you can ride out volatility and expect to come out ahead.

The takeaway

You must understand the risks, their value, their probability, and their consequences

You must know how you will respond

Once assessed you can decide how to manage them

Learn about risk and its history. It is worth your time. It is always there so any edge you build for yourself is worth some trouble.

I help people have more retirement income and larger, more liquid estates.

Call in Canada 705-927-4770, or email 

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