Risk is the possibility of losing something of value. Values (such as physical health, social status, emotional well-being, or financial wealth) can be gained or lost when taking risk resulting from a given action or inaction, foreseen or unforeseen (planned or not planned). Risk can also be defined as the intentional interaction with uncertainty. Uncertainty is a potential, unpredictable, and uncontrollable outcome; risk is a consequence of action taken in spite of uncertainty.
This, above, is an excerpt from the Wikipedia page on risk. Most of us ourselves also use these words to define risk. I find that while the words are good and do define risk, they however, do not lead to a true appreciation of the concept. This is the difference between, ‘I understand’ and ‘I get it’. I will attempt to bridge that gap here.
Any action we take has a range of possible outcomes. Each outcome has a probability of it occurring and an impact if it occurs. For example, consider the action of going out for dinner. The outcomes for this action range from ‘having a great time’ to ‘getting food poisoning’. Each outcome has a chance of it occurring and an associated impact (desired or undesired).
The existence of a range of outcomes introduces uncertainty. This uncertainty leads to the chance that an undesired outcome may come to pass and bring its undesired impact. The existence of the possibility of an undesired outcome is risk.
Now, we take on this engagement with risk, because we desire the positive outcome and its impact. In the above example, without the action of ‘going out to dinner’, there is no possibility of ‘having a great time’. In the desire for this outcome, we then have to necessarily engage with the possibility of ‘getting food poisoning’. This relationship between what is possible, what is probable and impact is what we call risk-reward balance.
The risk-reward balance, gives us the adage ‘high risk, high returns’. This is a myth. The distinction that is true is ‘taking on high risk, creates the possibility of high returns, not a guarantee’.
Going back to our example, let’s say, we have decided to take the action of ‘going out to dinner’. Let’s say, we fully understand (or at least instinctively understand) the involved risk. Here, we do a few things – ensure that the spouse is in good spirits, decide on a restaurant that has good reviews, not have roadside food, avoid spicy food, etc. Each of these actions reduces the probability of undesired outcomes, automatically increasing the probability of the desired outcome.
To recap…, all human action involves engagement with uncertainty. The engagement is necessary, otherwise there is no chance of the desired result. The engagement with risk, by nature, brings with it, the possibility of undesired results. We then proceed to manage the risk, and this leads to greater chance of the desired result.
So, is the case with investing. Investing is an action. Investing will automatically bring with it a range of possible returns. For the success of the investing action, we need to then proceed with managing the risk. We do this by using professionals, by introducing diversification, etc.
