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Archives for August 2010

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Importance of Understanding Risk When Investing

Accepting risk is acknowledging the possibility of losing some or all of the investment principal.  High risk typically means high volatility. When something is high in volatility, it is unpredictably irresolute. Both timing and degree of fluctuation are difficult to anticipate. When something is low in volatility its movements are predictable with a high degree of certainty, it is low risk.

Risk is not independent and should not be considered in a vacuum. Risk generally correlates positively with return. This means that as risk increases, so do potential returns. Unlike other risks we accept, there is no such thing as investment insurance to protect against bad investments.

When considering risk you must weigh the possible gains vs. the possible losses. The degree of risk that someone is willing to accept depends on a number of factors. One is simply personal preference. How much risk can be comfortably tolerated? A second is investment goal: Growth? Capital preservation? Income? A third is time horizon: how much time is there until the funds are required? High risk investments tend to do well over the long-term because time has a way of taming risk. Low risk investments do well in the short-term because they are more predictable and sometimes more liquid. There are many factors in determining acceptable risk; most of them tend to overlap.

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Averse to Risk? Most of us Are

Risk aversion is a trait common to most individuals.  This is why we buy insurance.  Most people must be compensated for accepting additional risk. This is why investors demand higher returns on riskier investments.  A risk averse person must be compensated for accepting additional risk even if the expected value is the same.  A risk neutral person only cares about expected value. [Read more…] about Averse to Risk? Most of us Are

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How Much Does Risk Cost? It’s too Expensive to Ignore

Risk is expensive. Most people are risk averse.  Both people and companies must be compensated in some way for accepting more risk. This is why individuals with poor driving records pay more for insurance and investors require higher returns on riskier investments.

The expense of managing risk is directly correlated with the expected losses.  Expected losses can be determined by multiplying the severity (cost) by the frequency. [Read more…] about How Much Does Risk Cost? It’s too Expensive to Ignore

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What are the Steps in Managing Risk?

With financial planning our goal is to minimize the cost of risk. Our primary tool in minimizing this cost is insurance, which transfers risk in exchange for payment (a premium). Insurance is all about managing risk, but how is risk managed?  There are three steps in this process.

Step One: Identify the risk.

What is the source of this risk?  What are the characteristics?  What is the expected frequency and severity?  Remember that expected cost = frequency x severity.

Step Two: How much risk am I willing to accept?

Financial considerations are typically the primary factor; how much risk can you afford to accept?

Step Three: How should the remaining risk, the risk that I am not willing to accept, be managed?

How much will each form of risk management cost?  Which is most cost-effective?  Determine the best way to deal with the remaining risk and monitor the success.  Make adjustments if necessary.

While the above are not hard and fast rules since every situation is different, they provide a general idea.

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Ways of Managing Risk

There are four main ways to manage risk: risk avoidance, risk transfer, risk reduction and risk retention. Each is applicable under different circumstances. Some ways of managing risk fall into multiple categories. Multiple ways of managing risk are often utilized simultaneously.

Risk Avoidance (elimination of risk)

Completely avoiding an activity that poses a potential risk. While attractive, this is not always practical. By avoiding risk we forfeit potential gains, be it in life, in business or in with investments.

Risk Transfer (insuring against risk)

Most commonly, this is to buy an insurance policy. The risk is transferred to a third-party entity (in most cases an insurance company). To be more clear, the financial risk is transferred to a third-party. For example, a homeowner’s insurance policy does not transfer the risk of a house fire to the insurance company, it only transfers the financial risk. A house fire is still just as likely as before. Risk sharing is also a type of risk transfer. For example, members assume a smaller amount of risk by transferring and sharing the remainder of risk with the group.

Risk Reduction (mitigating risk)

This is the idea of reducing the extent or possibility of a loss. This can be done by increasing precautions or limiting the amount of risky activity. For example, installing a security alarm, smoke detectors, wearing a seat belt or wearing a helmet are ways of employing risk reduction. Diversification of assets and hedging are forms of risk reduction with investments. Investments in information are a way of mitigating risk because you are better informed, thus reducing the uncertainty. Another way of employing risk reduction is the safety in numbers approach. When discussing risk transfer, we spoke briefly about risk sharing. The larger the number of people sharing risk, the less severe the shared effects will be. Statistically, only a small number of individuals in the group will experience an unfortunate event. Insurance companies exist based on this concept.

Risk Retention (accepting risk)

Risk retention simply involves accepting the risk. Even if the risk is mitigated, if it is not avoided or transferred, it is retained. Retention is effective for small risks that do not pose any significant financial threat. The financial status of the family or individual will determine the acceptability of a risk. A couple of examples of risk retention: A billionaire may not have to worry about insuring his car. An individual may not be able to afford or obtain health insurance. Both individuals are retaining risk, one is because they’re able to, the other is because they have to.  Risk retention augments risk transfer through  deductibles.  With a deductible, we retain or ‘self-insure’ small, frequent occurrences and only utilize insurance for needs over a particular dollar threshold, our deductible limit.

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Introduction to Risk

Risk is uncertainty.  Risk is the variability around an expected outcome. The larger the variability, the higher the uncertainty, the larger the risk. Risk is pervasive. Most activities involve some sort of risk. Accepting risk involves nothing more than a cost-benefit analysis. We choose to accept risk because we see the benefits as outweighing the cost.

Adverse decisions in accepting risk can be due to a number of things including influence of substances, lack of information, lack of understanding, lack of judgment or the existence of emotional factors.

We must accept some risk.  Risk is expensive. The purpose of risk management is to minimize this cost. What will give us the most value for our dollar in the cost benefit analysis of risk?  This is the goal of risk management.

Our aim in financial planning is to manage individual, personal risks. Personal risks involve risk exposures that reduce our individual wealth. These include: liability risk, income risk, longevity risk, asset risk and medical risk.

Below are a description of risks with common ways of managing them.  The primary purpose is to provide a brief description and show you where to find more information on the managing of this particular risk.  There are multiple ways of managing most risks, risk transfer is one way.  Insurance is a form of risk transfer.

Liability Risk:

Risk of being sued for damages to others.  Managed through liability insurance.

Income Risk:

Losing job, losing family breadwinner, losing ability to work (i.e. disability).  Managed through life insurance, disability insurance, social programs, etc..

Longevity Risk:

Outliving finances.  Covered through proper retirement planning and effective use of assets during the lifetime.

Asset Risk:

Losses to monetary and physical assets (house, car, investments, retirement).  Protection of physical assets are covered under property insurance, i.e. renter’s, homeowner’s, or auto insurance.

Medical/Health Risk:

High medical costs.  Covered through health insurance.

These are the risks that we manage through financial planning.  Business risks have similarities, but are also very different.  In addition to the above, there are many ways to reduce risk in both frequency and severity.