Chances Are Your Not Viewing Risk Correctly

What is risk?

Risk = Uncertainty. If the outcome of an activity is unknown, it is risky. But, that risk isn’t necessarily just associated with a bad outcome. The outcome could be that the project produces a positive return or a negative return. The stock price could go up, stay the same, or go down. It isn’t the fact that it could be a bad outcome that makes something risky. Rather, if the outcome is unknown, there is risk.

But, risk isn’t always a bad thing. If there isn’t risk, there generally isn’t a possible positive outcome. At least not one worth pursuing. So, risk can be good. As long as the risk itself is known and identifiable, a rational decision can be made.

However, I see a lot of people identify risk and then shy away from the choice, investment, project, or activity. This can often lead to the wrong decision. After all, no risk, no return. If we didn’t take any risks in life, we wouldn’t even learn to walk. To move past where you are today, chances are your going to have to take a risk here and there. In my view, if I had one change to make to my past, it would be that I wish I had taken more risks. Not less.

The best approach to considering risk is to attempt to calculate the real risk and then make a good decision. To calculate the real risk you should take the probability of the risk into account. For example, if there is a risk of losing $1,000 this sounds bad, right? But, if there is only a 10% chance that the loss will happen, it really isn’t very risky after all.

When considering risk, it is important to determine the “weighted risk,” if possible. To do this, you simply multiply the maximum downside loss, by the probability of the loss occurring. In the above example, the maximum downside is $1,000. And the chance of the loss occurring is 10%. So, the weighted risk is = $1,000 x 10% = $100. It is’t the $1,000 that should be the decision-making metric. Rather the weighted risk of $100 is the relevant risk. And those two numbers are very different. They can lead to very different decisions. This approach can be applied to everything from what company to invest in, to where to go for dinner. Everything is risky. Embrace it.

What you are probably thinking now is – determining the maximum loss is normally pretty easy. But, how do you quantify the probability of the loss? Not to put too fine a point on it, but – You guess. Sure, you can apply fancy statistical methods. But, you don’t have to. Those methods often include assumptions, which are just guesses too. Nobody knows what the future holds. Everybody is guessing. And if you are familiar with the decision at hand, you are likely in just as good of a position to make an educated guess as anybody else. Why not? Everybody is guessing anyway. Take Risks. Be You.

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