Tuesday, March 6, 2018

Risks

Definitions

Risk can be defined as ”A potential of gaining or losing something of value.” or ”An exposure to the chance of injury or loss.”

Personal risks

First I would like to say that risks affect on you in many different levels. For example, they affect on you through corporations, nations and global events like wars. I will keep things in personal level. Humans are very good in understanding risks related to their survival. Especially, when their intuitive decision-makingsystems are on. You can avoid an imminent threat to your survival without even noticing it. For example, changing your direction from the normal route, because of something is not feeling right. Survival in these cases means not hurting yourself physically in an imminent danger. You are not good in avoiding long-term risks. Modern world has less imminent threats than your brain thinks. This creates many problems that even the risk management experts do not understand.

You have many personal risks other than risks of physiological harm. Financial risk is maybe the most common risk you think about. Losing your job, or inability to pay your debt can cause you harm. You may lose your reputation if you do something really stupid or someone spreads rumours about you. You also have a risk of not being able to adapt to the changing world. Doing what you have always done before is your path of least resistance. Changing things is hard, even when it is necessary. People are also increasing their technology risks, because their dependence on technology is rising. Personal risks can compound in a long-term. Taking small, but unnecessary risks without suffering the consequences fast may lead to severe problems later on. For example, eating crappy food may not cause you any harm for decades, until one day you get a heart attack without any warnings.

Risk Management

Risk management is about probabilities. You need to understand them to understand risk. Repeatable events with fixed probabilities are easier to understand. For example, risks at the roulette table and lottery are fairly easily quantifiable. When you cannot calculate a probability of something happening, you cannot really understand risks. Uncertainty is not well understood. Managing risks without understanding power laws is one of the most common causes of financial destruction for institutions and in a personal level. The other common cause is not understanding complex systems and the second order effects in them.

You have to consider your risk appetite too. Some people cannot sleep well with moderate risks in their lives and some people cannot sleep well without them. Risks are not all bad things. Progress comes from taking risks. Some of them are managed and some of them are not. Humans have developed as a race by avoiding risks concerning on survival. Risk-seeking is about functioning against your basic instincts. It is hard, but many times worth all the effort. When you understand the risks you are taking, it is easier to get better results. You have to ask yourself some questions to understand risks better:

  • What are the consequences of not doing it? What will it cost you? What are the unwanted outcomes that can come true? How will you react if they happen to you?
  • What are the positive consequences? What will you benefit? How will you react? How do you feel about the outcoming benefits now?

Risks can also be quantified in terms of impact of their consequences. You should use a simple scale in how you want to rate the impact of the risks. Make it reasonable. For example, you can use a three-level scale of impact for risks. Risks with high, medium or low impact. Think about high risks all the time. Risks with medium impact are not that important, but you should check them regularly. Low risks are not that relevant. You should still check them occasionally. You should also remember that low and medium impact risks can become high risks through compounding. In this case, it means taking many small risks many times.

Asymmetric risk

There are two kinds of asymmetric risk. Good ones and the bad ones. An asymmetric risk means that the reward is a lot bigger than the risk taken, or the reward is a lot smaller than the risk taken. In other words, the expected payoff is high or low, depending on the risk taken. Nobody wants to take an asymmetric risk where the expected payoff is crappy. Most often, this happens, because the risk taker do not understand what he/she is doing. This happens to the most respected experts too. Especially, financial market participants do not understand risks. One reason is that they haven´t noticed the power laws in the markets or understand them. Many assumptions about the returns in the financial markets are made by thinking through a normal distribution. The problem is that returns in financial markets do not really realize through them. Most of the profits are made with a small number of stocks or during the small number of days, etc. In other words, extreme outcomes in financial markets have higher probabilities than using normal distribution tells you.

It is easy to make a statement that you should avoid all the asymmetric risks, where the downside is enormous compared to the expected payoff. For example, not going to see a doctor, when you have a severe chest pain. Not going to a doctor can cause a death and going to the doctor can save you. You can also take lots of asymmetric risks where the probabilities are against you. When expected payoff is high, you need smaller amounts of successes. This doesn´t mean that all the risks come true and payoff is always high. You should be ready for many losses with these kinds of risks. Overall, the expected payoff will be good in the long run.

Sources:

Smart -> Risk, Andrew Holmes
Risky Strategy, Jamie MacAlister
Fooled by Randomness, Nassim Taleb

There are some psychological biases that are have effects on the risk taking. I will get into those biases later.

Have a nice end of the week!

-TT

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