Most people don't have a good concept about how to consider financial risk when it applies to them as individuals. Here's a start:
Another word for risk is uncertainty. Financial
folks often talk about “risky assets.” By that they mean assets that do not
come with a guaranteed return. Investment textbooks contain formulae to measure
risk based on volatility of returns, standard deviation of returns, variance of
returns, ratios of those statistics relative to expected return and so on and
so forth. Lots of measures but they all have to do with how uncertain the
return is.
All the mathematical equations in the world miss a very
large point about real risk as applied to individuals. You are only one person,
and you only get one result, not an array of possible results.
A Simple Illustrates Individual Risk
You have an opportunity to invest in a stock that after one
year will be worth either nothing or earn 1,000 times the original investment.
Each result has a 50/50 chance. To make this bet, you must put up everything
you own up to $10 million. A math guy would tell you that your expected
earnings are 500 times your investment—a very positive result. We'd all like a
piece of that investment opportunity.
Except . . .
I don’t know about you, but I’m not worth $10 million. This
deal requires me to invest everything I have. I’m retired and if I lose it all,
I will be in very deep trouble. You could change the 1,000 multiplier to 10,000
or even 1,000,000 and I still could not afford to take the gamble. It is too
risky for me because losing wipes me out, and I do not have a viable way to
recover any semblance of a decent standard of living.
Bill Gates, however, could hop on this investment with
little thought (other than to make sure the deal is as represented.) While he
wouldn’t want to lose $10 million, the loss is less than .01% of his reported
100 billion of assets1 — a drop in the bucket. If you are rich
enough that you can easily afford a $10 million loss, this is a great deal.
If I were 23 years-old again with most of my working years remaining,
I’d make that bet in a heartbeat. Sure, I only had a net worth of a few
thousand bucks, but at that age I’d risk all of it (say $5,000) to earn $5
million.
When we look at financial risk as an individual, we can’t
just look at it as a financial wonk would and based our decision on averages or
"expected values." We must consider what it means to us if the
investment pays off and what happens if it doesn’t.
* * * * *
James M. Jackson authors the Seamus McCree mystery series.
Full of mystery and suspense, these thrillers explore financial crimes, family
relationships, and what happens when they mix. False Bottom, the
sixth novel in the series—this one set in the Boston area—is now available. You can sign up for
his newsletter and find more information about Jim and his books
at https://jamesmjackson.com.
1 Bloomberg Billionaires Index
* * * * *
James
M. Jackson authors the Seamus McCree mystery series. Full of mystery and
suspense, these thrillers explore financial crimes, family relationships, and what
happens when they mix. False Bottom,
the sixth novel in the series—this one set in the Boston area—is now available. You can sign
up for his newsletter and find more information about Jim
and his books at https://jamesmjackson.com.
1 Bloomberg Billionaires Index
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