As we go through life, new experiences serve to modify our views. Young people seem to thrive on taking risks, but with age they tend to reduce or eliminate risk altogether. The older we get, the better we know ourselves and the better we understand how we would handle – or not handle – any form of loss. A man who sleeps well at night is typically a man who manages his risk.
We all have different perceptions of risk, which should really come as no surprise. After all, we are built differently; we think differently; and each of us has a different genetic make-up and unique life experiences.
We all encounter risks in our daily lives, and while these may sometimes be quite minor, we nevertheless choose the path of least resistance – the best possible outcome with the lowest risk. It is human nature to pursue pleasure and avoid pain, but for someone who is forced to make a decision involving more than one unknown outcome, taking a risk can create confusion.
Economists make a distinction between risk and uncertainty. When faced with multiple courses of action, we must always weigh up the possible outcomes. It may be possible to rank these according to the best, the average or the worst outcome, but by forecasting each eventuality, the risk-taker is not acting in haste.
If the consequences cannot possibly be known, then the decision must be based on an analysis of all probable outcomes, and hopefully the correct choice will be made to yield the best, or at least the most desired, result. After all, crossing a busy road when you are in a rush may get you to your destination sooner, but it also increases the likelihood of meeting with an accident.
When applied to investing, such as in the stock and bond markets, this same approach could mean
analysing investments, searching for growth or value, or simply ensuring that you understand terms such as “standard deviation” and “volatility”, and how these relate to each investment choice. So by understanding the worst possible outcomes, an investor can prepare for the worstcase scenario, both financially and psychologically.
But it doesn’t have to end there. Sophisticated investors can be more pro-active when managing risk. Diversification across asset classes is important, as is adhering to a strategy that limits the exposure to any one security or position. Investors can also use “stop losses” or “options” to protect a portfolio against any downside market movements. Sometimes it can even be said that “cash is king” – a decidedly low-risk approach, which has already served investors well on three or four notable occasions in the past 15 years.
The problem many investors have in today’s low-interest rate environment is that they are being lured into higher-risk investments because traditional sleep-easy, interest-bearing instruments or
deposits are no longer providing any yield.
Seeking higher returns exposes investors to higher-than-normal risk, while remaining content with the safe haven of a deposit account exposes investors to another type of risk altogether: Inflation Risk, which erodes spending power as living costs continue to rise.
It stands to reason that the higher the risk involved in any venture, the higher the reward will be if all goes to plan. An investor, like an entrepreneur, must take some risk to make money, and these risks can be managed in the same way.
By committing only a limited amount of funds to any individual investment, and insuring against loss, the right balance can be struck between risk and reward.
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