What is financial risk?
Photo: Vanio Beatriz. Source: Wikipedia
Risk is the chance that something bad will happen. When we invest, we don’t want bad things to happen to our money. So we try to avoid risky situations. The problem is, there’s no way to insure against all the risks we face with our money. There seems to be an infinite number of flavors of financial risk: credit risk, liquidity risk, inflation risk, longevity risk, shortfall risk, earnings risk, market risk, fraud risk. The list goes on and on.
All risks involve an unknown outcome. Some risks we know: the known unknowns. We can compute their odds. In backgammon we never know what a single roll is going to be, but the chances of rolling double-sixes on the next roll are always one in 36. Some risks we don’t know—unknown unknowns. It’s the unknown unknowns that scare us. When I played backgammon for money in college, there was always the possibility my opponent would overturn the board walk away. I couldn’t calculate those odds.
Financial economists and quantitative analysts use volatility as a proxy for risk. It provides them with a way to measure the variability of returns. But this tells only part of the story. The market’s volatility has been quite low over for several years now, but that doesn’t mean it hasn’t been risky.
The best money managers are also risk managers. The key is understanding both measured and unmeasured risks, and knowing when a risk is worth taking, and when it isn’t.
Douglas R. Tengdin, CFA
Chief Investment Officer