What is Risk of Ruin
Risk of ruin is the probability of an individual losing substantial trading or gambling money (known as capital base) to the point at which continuing on is no longer considered an option to recover losses.
Risk of ruin is typically calculated as a loss probability. Also known as the "probability of ruin."
BREAKING DOWN Risk of Ruin
Risk of ruin is generally identified through advanced financial modeling. It is usually 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.
Diversification can help to mitigate high risks of ruin. Ultimately most investors will have a threshold level for which capital cannot fall below to avoid unrecoverable losses while still seeking to generate profits. Losing all of an entity’s capital assets can also be costly resulting in bankruptcy and other situations which have their own additional expenses.
Risk management programs can be constructed in various ways and varieties based on 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 more. Institutional risk management is typically relied on for all types of investing scenarios in the financial industry while personal risk management can potentially be more easily overlooked or miscalculated.
Estimating Risk of Ruin
In a single asset investment the risk of ruin is usually considered to be a probability that an investor’s entire investment could be lost. This probability is typically generated through scenario modeling that provides a measure of the value to be lost per movement in price or yield leading to total investment losses.
Generally, the concept of diversification was developed to mitigate the risk of ruin. Financial models can be built by risk managers which build on single asset risk of ruin probabilities. Multi-investment models seek to calculate the probability of ruin from each investment. Generally, 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. 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.
Investing a large portion of a portfolio in risk free assets is the best way to manage a capital base and mitigate against the risk of ruin. Modern portfolio theory builds out this concept by creating optimal allocations for investors based on their risk tolerance.
Personal investors, technical analysts and day traders who do not strictly adhere to portfolio management theory will likely follow the 2% Rule. The 2% Rule is a well established rule in the investing industry that suggests an investor should not bet more than 2% of their capital on a single investment trade.
Institutional Investment Banks
In the institutional market several occurrences of mismanaged risk of ruin have led to steep losses and even bankruptcy. The bankruptcy of Lehman Brothers and the 2008 financial crisis is one example that had several implications for the market from legislation enacted through the Dodd-Frank Act. The 1995 bankruptcy of Barings Bank provides another example of mismanaged risks that led to detrimental losses for a large institutional bank.