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.

Diversification

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.

RELATED TERMS
  1. Accepting Risk

    Accepting risk occurs when a business acknowledges that the potential ...
  2. Price Risk

    Price risk is the risk of a decline in the value of a security ...
  3. Risk Profile

    A risk profile is an evaluation of an individual or organization's ...
  4. Risk Capital

    Risk capital consists of investment funds allocated to speculative ...
  5. Investment Ideas

    Investment ideas are specific views, plans or ideas on ways to ...
  6. Financial Risk

    Financial risk is the possibility that shareholders will lose ...
Related Articles
  1. Retirement

    Protecting Your Retirement Assets

    Your golden years are meant to be stress free. Keep them that way by protecting your assets.
  2. Insights

    How to Invest In Developing Markets

    Developing markets can be attractive additions to many investor's portfolios, but carry additional risks that must be considered.
  3. Managing Wealth

    Modern Portfolio Theory: Why It's Still Hip

    Investors still follow an old set of principles, known as modern portfolio theory (MPT), that reduce risk and increase returns through diversification.
  4. Investing

    Scenario Analysis Provides Glimpse Of Portfolio Potential

    This statistical method estimates how far a stock might fall in a worst-case scenario.
  5. Managing Wealth

    Achieve Optimal Asset Allocation

    Minimize risk while maximizing return with the right mix of securities and achieve your optimal asset allocation.
  6. Managing Wealth

    How Risky Is Your Portfolio?

    Find out how you could be subject to larger losses than you think.
  7. Small Business

    Identifying and managing business risks

    Running a business comes with a lot of associated risks, but there are an equal number of ways to prepare for and manage them to lessen their impact.
  8. Retirement

    6 Risks to Your Retirement Plan

    There are six big risks to running out of money in retirement. Here's how to manage them.
  9. Investing

    Understanding Risk is Key to Your Investing Strategy

    Here's why considering all types of risk is crucial for a successful investment plan.
RELATED FAQS
  1. How does market risk differ from specific risk?

    Learn about market risk, specific risk, hedging and diversification, and how the market risk of assets differs from the specific ... Read Answer >>
  2. What are the primary sources of market risk?

    Learn about market risk and the four primary sources of market risk including equity, interest rate, foreign exchange and ... Read Answer >>
  3. What are the major categories of financial risk for a company?

    Examine four major categories of financial risk for a business that represent potential problems that a company may have ... Read Answer >>
  4. What is the difference between risk avoidance and risk reduction?

    Learn what risk avoidance and risk reduction are, what the differences between the two are, and some techniques investors ... Read Answer >>
  5. Why are mutual funds subject to market risk?

    Find out why mutual funds, like all investments, are subject to market risk, including how the different types of market ... Read Answer >>
Trading Center