Risk is not inherently a bad thing; so many people automatically see it a such. Thus the term Risk Aversion. Risk is simply a catch-all term for future uncertainty - both positive and negative.
Risks are always there, but can be dealt with in different ways. You can transfer risk - like getting insurance - someone else pays if your house burns down. You still have to 'pay' for the risk (insurance) but you literally take the uncertainty out of your fiscal dispersment should such an event happen.
You can also mitigate risks. For example, if a fire is likely, you would install a smoke alarm, get a Carbon monoxide detector, and buy a fire extinguisher. You've basically put on a bullet proof vest in terms of risk protection. You'll still take the hit, but you (and your bank account/house/business) will live.
You can accept risks. If a risk of say, managing your own property is that the tenant might call you in the middle of the night and you can't afford a property management service, you simply acept the risk, end of story. You essentially tell yourself - "Hey, this wouldn't be so bad, and the cost of removing the uncertainty of never having to deal with that event would be too much money" It comes out again at this point that risk is uncertainty and costs nothing, certainty is going to cost you money. Plain and simple.
For example, let's say you're worried about mortgage (interest) rate fluctuations. You mitigate the risk (make it better) by doing your research, checking indocators like bond yeild indices, and checking with some knowledgable bankers or investors. You then take out a variable rate loan if you tink you can accept the rate risk (fluctuations) or you lock in at a fixed rate if you are unable or unwilling to accept that risk. The catch/tradeoff? That extra bit of fixed rate certainty can often cost you 2%-3% on your mortgage interest rate; a difference of up to 50% the cost of your interest payments already. You therefore are buying certainty form the person (the bank) who you judge best able to handle the risk.
I hope this helps realign people's use of the word Risk and lets you think just a little more creatively about what exactly people mean when they throw around risky words :) Risk-return is an enormous concept in Finance and business. More on the Return side later today!
AIML
What did you make of the piece on the CBC we were listening to about risk averse personalities and happiness?
ReplyDeleteI agree with the anecdotal evidence that those with low risk aversion tend to be happier; I'm not sure as to the direction of the causality.
ReplyDeleteThose who seem terrified about risk and uncertainty are usually far less likely to actually think about the positive aspects of any action in life, and instead focus on the negative. Since risk is essentially negative consequences of uncertainty, it would lead me to believe that it might make people unhappy to focus solely on the bad things that may happen in life!
"Since risk is essentially negative consequences of uncertainty, it would lead me to believe that it might make people unhappy to focus solely on the bad things that may happen in life!"
ReplyDeleteBut didn't you say in the first paragraph that risk includes positive uncertainty as well?? ;-)
Very true, those were contradictory ways I described risk. Likely, a better model would be that Loss is the negative side of uncertainty and gain is the positive side. A more appropriate term would be volatility in describing both neg and pos fluctuations. Risk would be the chance of negative outcome of future volatility, whereas return is the positive side.
ReplyDeleteThanks for the correction - I'll be more careful in the statements next time!
AIML