#009: On risk
Author’s Note
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The uncertainty principle "protects" quantum mechanics. Heisenberg recognized that if it were possible to measure the momentum and the position simultaneously with greater accuracy, the quantum mechanics would collapse. So he proposed that it must be impossible. Then people sat down and tried to figure out ways of doing it, and nobody could figure out a way to measure the position and the momentum of anything a screen, an electron, a billiard ball, anything with any greater accuracy. Quantum mechanics maintains its perilous but accurate existence.
~Six Easy Pieces By Richard Feynman
Risk implies future uncertainty about deviation from expected earnings or expected outcome. Risk measures the uncertainty that an investor is willing to take to realize a gain from an investment. Evaluating risk follows the same uncertainty principle. Just like quantum mechanics, accurately quantifying risk is impossible.
Given the limitations of human foresight, with time comes risk. This inherent risk must be sharply distinguished from the kinds of risk that are created by activities such as gambling or lottery. Risks are of different types and originate from different situations. We have insurance risk, liquidity risk, sovereign risk, business risk, default risk, etc. Various risks originate due to the uncertainty arising out of various factors that influence an investment or a situation.
Economic activities for dealing with inescapable risks seek both, to minimize these risks and shift them to those best able to carry them. Those who accept these risks typically not only have the financial resources to ride out short-run losses but also have lower risks from a given situation than the person who transferred the risk. For example, an institutional investor can reduce overall risks by engaging in a wider heterogeneity of risky activities than a farmer.
So, it becomes very important to be aware of your respective risk profile. An individual's risk profile is determined by a combination of various factors. In many cases, the individual makes the wrong investment choices because they are not aware of their risk tolerance. Risk tolerance is based on your ability — financial as well as emotional — to lose much of your original investment in exchange for greater potential returns. You could either be risk averse, risk loving or risk neutral, depending upon different situations.
How to minimize risk?
Risk cannot be eliminated completely but it can surely be minimized.
Understanding various Risks
Familiarize yourself with the different types of risk. Most financial risk can be categorized as either systematic or non-systematic. Systematic risk affects an entire economy and all of the businesses within it; an example of systematic risk would be losses due to the recession caused by Covid-19. Non-systematic risks are those that vary between companies or industries. These risks can be minimized through careful planning and knowing the difference between asset classes and at the same time understanding asset-based financial risk.
Planning for a Time Horizon
Your time horizon is a set date, usually months, years or even decades in the future, at which time you will achieve your goals. Generally, If you have a relatively longer time horizon, you may feel more comfortable taking on riskier financial decisions. If your time horizon is relatively short, you may need to minimize risk. Moreover, be acquainted with your risk tolerance.
Diversification and Hedging
Reduce your risk level by allocating assets widely. For instance, your portfolio should include stocks, bonds, cash equivalents, and possibly other investments such as real estate and gold. The proportion of these allocations will depend on the level of risk you want to shoulder in totality. Another great way to mitigate the inherent risk is to hedge your investment. Hedging is not free, and the idea is not to make money from this investment, rather, it is to protect yourself. Consider, for instance, the premium you pay for your health insurance.
Before you leave remember this…
Important Takeaways:
Risk takes on many forms but is broadly categorized as the chance an outcome or investment's actual gain will differ from the expected outcome or return.
There are several types of risk and several ways to quantify risk for analytical assessments.
Risk can be reduced using diversification and hedging strategies.
That’s it for today dear reader. See you next week.
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