Understanding Risk

Posted on: 13 Apr 2022

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Risk is a very interesting word. It generally comes with negative connotations and is often regarded as something to be avoided if at all possible. But is that right? In this article and future conversations, we’re really keen to explore the idea of risk.  Its various uses (and often mis-uses) as a term.  Why risk isn’t always something to be feared and in many instances is something to be embraced. And how we should build risk into both our financial planning and investment strategies.

There are plenty of definitions of the word Risk. The Oxford English Dictionary defines it “as a chance or possibility of danger, loss, injury or other adverse consequences”. But using that definition means that pretty much everything we do carries an element of risk and as such, isn’t really that helpful. 

A risk professional will require you to understand the likelihood of a ‘risk event’ happening and the impact of that event and that certainly helps think about risk in a more manageable way. If we leave the house without an umbrella, then there is a reasonably highly possibility (in the UK!) that we may get wet, but the impact on us is fairly minimal.  The chances of us being struck by lightening is extremely low, but the impact could be fatal. So we might decide to leave the house without an umbrella and risk getting wet, but would be foolish to stand in a field holding up an umbrella in a lightening storm.  

Understanding risk as Impact x Likelihood can help us think about how we want to manage it.  Should you avoid it if you can?  Are you happy just living with it?  Or can you take some steps to at least partially mitigate the worst effects. In a similar vein, you might be happy with the risk of gambling £5 on the Grand National, but you would be unwise to put your house up as a bet. 

Our daily risk decisions

We have mostly learnt to assess those risks which we come across in our day to day lives. We know how to put them into context, so crossing the road doesn’t normally cause us stress because we are comfortable in the steps we take to mitigate such risk (using a zebra-crossing and looking both ways). We have confidence in our ability to execute the steps necessary based on our knowledge and experience. When we start to feel the stress of risk is often when we don’t have either knowledge or experience.  Think back to the start of the pandemic when we had no information and were all very wary.  Behavioural expert and psychologist Daniel Kahneman in his book Thinking Fast and Slow evidences how we are naturally risk averse as we tend to feel the pain of loss more intensely than we feel the joy of gain.  This causes us to protect what we have, rather than go after what we don’t have.  He also evidences though how as a species, we are very poor at assessing risk for those things outside our day to day lives.

And what about financial risk?

As financial planners and investment advisers, risk has a significant role in the work that we do.  Our overall objective is to help our clients manage financial and investment risks that could derail plans to achieve your goals.  This might be related to job and income security, health and mortality or other changing circumstances. We need to factor in these issues and provide, where possible, solutions to help mitigate those risks.  As we highlight above a client’s perception of financial risk will be heavily influenced by their past experience and their level of knowledge and a key part of our role is to educate and support to reach a shared understanding.   

And of course, financial plans will be impacted by investment markets which come with another whole layer of potential confusion about what risk means.  Is it the risk of short-term gyrations in the price of something or the risk that you could lose all your money?  Is the return questionable or is the capital itself at risk?  The last two years have been quite something in terms of unexpected outcomes, sometimes called Black Swan events – things with low likelihood but high impact. The Brexit vote manifesting itself in the actual departure from the EU.  And didn’t we think that upheaval would be the most significant challenge we would face in the near term only to be followed by the ‘Global Pandemic’ that was (and still is) Covid-19 and all its variants. Now, after all of this we face the atrocities that are going on in the Ukraine. You can’t avoid those risks as they are outside our control but you can still plan to manage the impact of these or any other combination of ‘knowns’ and ‘unknowns’ as Donald Rumsfeld the former US Defence secretary famously said.   

The Oracle of Omaha, Warren Buffett, is regarded as one of the greatest investors of all time and there are many lessons that we can learn from him. I will leave you with one quote from him – “Risk is about investing in something you don’t understand”. Part of our aim as a firm is to help educate and inform, to hopefully de-mystify some of the terminology and perceptions that many of us have. The more we understand, the less risk we take.

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