What Is Risk of Ruin?
Risk of ruin is the probability that an individual will lose substantial amounts of money through investing, trading, or gambling—to the point where it is no longer possible to recover the losses or continue.
Risk of ruin is typically calculated as a loss probability, where it is known as the "probability of ruin." These calculations can be conducted using a value-at-risk (VaR) measure or through techniques like monte carlo simulation, among other methods.
- Risk of ruin is the chance that an individual will lose such a substantial amount from an investment or bet that they will be unable to recover from the loss.
- Calculated as a probability of failure, financial modeling techniques are often employed to come up with a figure.
- Risk of ruin will depend on the amount of assets one has at stake versus overall assets and the nature of the investment or bet.
Understanding the Risk of Ruin
Risk of ruin can be identified through advanced financial modeling and expressed as a probability. The complexity of the financial modeling methodology involved in calculating risk of ruin will typically depend on the number and variety of investments involved in a comprehensive trading portfolio.
In basic terms, the risk of ruin in gambling and investing is not so different as it depends on how many bets (investments) are placed and how much capital there is to cushion probable losses. The main difference being that investments are not zero-sum bets. Each investment has different risk profiles and payout probabilities, with some risking all capital and some guaranteeing a return of principle regardless of performance.
Controlling the Risk of Ruin
The concept of diversification was developed, in part, to mitigate the risk of ruin. Multi-asset portfolios can be extremely difficult to build risk management strategies for because of the infinite number of scenarios involved with investments across a portfolio.
Some investments, such as bonds and funds, have a great deal of historical data to allow for extensive analysis of the probability given a wide range of parameters. Others like custom derivatives are often unique and sometimes hard to properly analyze for exposure. On top of this, there are always black swan events that can upend even the most complex risk management model. For this reason, most investors rely on asset allocation models that invest a base level of capital in risk-free or very low risk assets while taking higher risk bets in other areas of a portfolio.
Risk management programs can be customized to the investor and type of investments involved. Risk management programs will vary across disciplines with some standard practices in the financial industry developed for investment management, insurance, venture capital, and so on. Institutional risk management is typically required by regulation for all types of investment scenarios in the financial industry and best practices such as actively monitoring areas like counterparty risk are widely used. Personal risk management in an investment portfolio, however, is often overlooked or miscalculated.