A different way of looking at risk
Updated: 6 hours ago
A different way of looking at risk
Writer: Klinsmann Lee
How is risk usually defined:
There are many types of risks such as business, economic, environmental, liquidity, credit or health risks.
Risk often focuses on the negative and undesired consequence of an outcome.
In Finance, risk is defined as “future uncertainty about deviation from expected earnings and unexpected outcome”. [1]
In Finance class, volatility is often used as a measure of risk.
However, is volatility = risk? Can we define risk in another way?
Is there another way to look at risk:
To me, risk can also be looked at as “Do you know what you are doing?”
One can perceive skydiving as risky while another can perceive skydiving as not risky given his experience in performing the task. To see things in perspective, the average injury rate is 0.3 injuries per 1000 jumps for experienced skydivers. However, the average injury rate jumps to 4 injuries per 1000 jumps for novice jumps with a modern square parachute. [2]
As we can see from the example, risk can be decreased from experience. The nature of risk is still present with skydiving but there can be ways we can minimise the injuries from skydiving.
In business, a volatile earning may not mean the company is in a risky business. If the business is cyclical, it will perform poorly during economic downturns and well during economic expansion. A good management team may successfully navigate such business cycles, making the company “less risky”.
Likewise, an applicant with a terrible credit rating may not mean that he or she will be unable to repay the loan. It is crucial to also understand the character of the applicant, his principles and why he or she has a bad credit rating in the first place.
In investing, a volatile stock price does not mean it is an undesirable company to invest in for a risk-averse investor. Likewise, a stable stock price does not mean that the company’s stock price will remain stable in the future. Adverse business events can cause stable stock prices to collapse.
I believe successful risk management is about understanding the fundamental, principles and character factors.
Why is managing risk important:
It is a common understanding that to obtain a higher return, one should expect a higher risk on the project or investment.
Successful risk management is about balancing the risk and returns for the company, ensuring that the company is enhancing value. It is about safeguarding the firm’s capital.
Managing risk is also about minimising the negative outcomes that may occur. Every decision will have both expected and unexpected consequences. Taking steps to manage these negative consequences is important.
I like the way Warren Buffett perceives risks as: [3]
The risk of a permanent capital impairment.
The risk of inadequate return on capital.
For investing or lending, capital protection is important. Assume that you have $100 and lose 50% (you now have $50). To return to $100 (initial capital), you require a return of 100% ($50 (return)/$50 (initial capital)).
Negative outcomes may inevitably happen even with proper risk management. However, proper risk management can help reduce the likelihood of negative outcomes.
Conclusion:
Volatility is only one way of looking at risk.
Another way of looking at risk is to understand what are the fundamental factors driving the risks.
Risk Management is important to balance the risk and return for an organisation.
References:
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