Using Logic To Examine Risk

By Brian Bloch AAA

In 1660, Blaise Pascal did some pioneering work on risk. He was dealing with theology, but the implications for the capital market are unmistakable. His original concern was the expected value of believing in god.. He attempted to convert nebulous uncertainties into calculable probabilities - what we now call risk. His "expected values" are the basis of modern risk theory. Pascal demonstrated that uncertainty is about people, their beliefs and their courage, while calculated risk is based on information, knowledge and credible scenarios. Together with his colleague, Pierre de Fermat, Pascal came to the conclusion that people are naturally risk averse - the more risk is involved with a particular asset, the greater the return that investors will require as compensation. However, many consumers have a skewed perception of the risk they actually are taking on. In this article, we'll take a look at how consumers' often skewed perceptions of risk can be just plain risky.

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Risk Today
One of the prices we pay as a result of our natural risk aversion is an insurance premium. Equities work in much the same way by offering a risk premium to compensate investors for the higher risk they carry compared to lower risk investments such as cash or government bonds.

If the risks of a particular investment are lower or the gains higher than the value of potential losses, people are willing to take chances. This is perfectly rational – in theory. But what if the risks only seem lower or the rewards seem higher? Then there is a problem for the investor, but big money to be made by the financial services industry. (For further reading, see Determining Risk And The Risk Pyramid.)

Asset allocation expert Roger Gibson stresses that "it is very rational to be risk averse," but investors "must understand and prioritize all relevant dangers in the context of the situation." In practice, this may not be easy.

Common Dangers in the Real World of Investment
A fundamental trap arises when people are unaware of the risks they really are taking and/or of their own true risk profile. In fact, this point crops up again and again in investment literature, but knowledge alone does not help much unless the investor really and truly understands the amount of money he or she stand to lose, the probability that this will occur and the personal or psychological effects this loss may cause.

In the financial services industry, the problem with consumer misunderstanding of risk is twofold. First, professionals who sell financial products tend to downplay the risks in order to make a sale. Also, people not only get tempted by talk of big gains, but when they buy a financial product or enter into a transaction they are also unaware of how much money they can lose or what it feels like when it happens. Taking a big loss in an investment can be a serious blow and, like physical pain, it's hard to identify with unless you've felt it yourself. This scenario can cause investors to be unaware of risks they are taking on, leaving them with an investment that does not suit their risk profile. When reality sets in, investors may become disillusioned and angry. But by then, it may be too late. (For more reading on risk, check out: Personalizing Risk Tolerance and Redefining Investor Risk.)

Solving this problem is relatively easy, but only if you know the problem is there in the first place. This is a case where what you don't know can hurt you, but investors can avoid this pitfall by ensuring that they read or ask enough questions about an asset or financial product to understand truly what they are getting. For many cautious and prudent people, obtaining an objective second opinion may be indispensable.

Similar Problems in the Insurance Industry
The same principle applies to the insurance industry, but in reverse. Telecom companies and other utilities are sending people all manner of insurance offers together with their bills. For a modest fee, you can insure your boiler, mobile phone and various parts of your body.

However, if these are pieces of equipment that are unlikely to fail, the money is wasted. It is tempting for cautious individuals to cover all risks, but this is exploited frequently by insurers. Although there is plenty of literature both on and offline about what is wrong with the insurance industry, the uninformed are always vulnerable. As a result, consumers should be wary of such "junk insurance."

Domestic appliance insurance and extended warranties may insure against a risk that is either extremely low or too unpredictable - offers to insure against rising gas prices, for example - to be worth betting on.

Similarly, fridges are reliable enough that years of guarantee are superfluous. Payment protection insurance for those who become ill or redundant sound important, but these policies are expensive. They may be quite unnecessary for people with secure jobs or whose health coverage is already adequate. (For related reading, see Buying Life Insurance: Term Versus Permanent, Shopping For Car Insurance and Long-Term Care Insurance: Who Needs It?)

The Risk of Bad Money Management
Insurance is not the only time that consumers misjudge risk - this also occurs in investing. Therefore, although very few investors plan to gamble, they often do. The enormous number of misselling scandals, not to mention those that have never surfaced, reveal the very different dangers in the investment sector.

After all, it is not only the assets themselves that can be risky, but also the way they are managed. Consequently, many people lose money by taking risks they probably would have avoided had they been aware of them.

For example, many people buy into mutual funds believing they are actively managed and that the conscientious and experienced experts who run them will move fast to minimize losses. However, what many people fail to realize is that mutual funds generally are obliged to remain invested almost fully in the market and, as a result, tend to go up and down roughly in line with a market's index.

The problem here is that people make the very understandable mistake of thinking that fund managers lower risk by managing things really well. This is indeed possible, but in reality, it is generally not the case. In fact, according to information released by Standard and Poor's in July of 2006, actively managed mutual funds have, on average, underperformed their relative Standard & Poor's benchmarks for the past five years. (For more insight, read The Lowdown On Index Funds and Wrap It Up: The Vocabulary And Benefits Of Managed Money.)

The Wrong Psychology
Psychology also plays a role in the level of risk that consumers in the financial industry take on. Large losses convert some risk-averse people to risk lovers in an attempt to recover their losses. Unethical sales people can exploit this greed and fear by advising people to take advantage of "great buying opportunities," when, for example, the overheated hi-tech market started to tumble in 2000. The longer a boom lasts, the more risk-averse people get sucked in as they see their risk-friendly friends get rich.

There is a large amount of literature on mass psychology, but don't bank on your broker knowing about it, let alone doing any thing about it. Investors need to ensure that they fully inform themselves about the state of the relevant market. They also need to know exactly what they are buying, who is selling it and why.

Particularly in the relatively opaque financial services industry, products and their risks are often not what they seem. By staying informed and using simple logic to examine the risk in their portfolios, investors can take control before the damage is done.

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