What is your risk level (part 3) update

There are different types of winning …. and losing

              Let us start with a quick review of how we perceive risk from part 1 and expand on the concept. Risk can be related to volatility. High risk can imply great or high volatility in relation to expected outcomes or solutions. Suppose a desired outcome is winning exactly $5,000, what is the likelihood of getting our desired outcome if the possible range of outcomes could be from $10,000 to -$10,000 with an equal chance of any integer on a single draw. Low risk suggests predictability or stability in the expected outcomes or solutions i.e. if our desired outcome is 1, what is the likelihood of drawing 1 (on a single draw) if the values available are between 2 and 0. In our first example, if we need to get $5,000 we will be very disappointed because the risk is so great that we will not get $5,000 (the odds are 1 in 20,000). However our upside potential (risk of getting equal to or more than $5,000) is much better. Our odds have improved to 5,000 in 20,000 or 1 in 4. We may be disappointed with the selection but not unhappy with the outcome.

             Risk can also relate to a specific outcome and the probability of that outcome. Assume option 1 has a 25% probability (1 in 4 chance) of making $1,000 and a 75% probability (3 in 4 chance) of making $0. Assume it costs $250 to participate. Remember, in business, finance and especially in investing there is always a cost to participate, if someone tells you there is no cost keep looking until you find it (I will get off my soapbox now). Option 2 has the same cost to participate but the probabilities are reversed. Now it is a 75% probability of making $1,000 and only 25% probability of making $0. Option 1 is substantially more risky than option 2. The risk is not in earning an amount different than the desired outcome ($1,000) but the likelihood of realizing or getting the desired outcome.

             Many business risks deal with a range of possible outcomes from very successful to significant lose. However, the payout or benefit of a successful outcome may be so great that the risk may be considered acceptable. Conversely, the cost of failure may be relatively small so that any lose is not particularly damaging. A business may be able to sustain a number of relatively small losses if the occasional success is great enough. In that case a risky venture, meaning a venture with significant volatility, may be not only acceptable but quite profitable. If one is accurate in predicting the probability (likelihood) of the possible outcomes then the risk of the unknown happening is greatly reduced. If one is uncertain of the possible outcomes then the exposure to risk can become enormous.

             We generally see that in order to generate the maximum possible wealth a certain amount of risk is usually involved. The very definition of increased risk as we discussed earlier, that results vary significantly from expected outcomes, suggests that there is likely a large element of the unknown or even unknowable in such situations. By 1985 Steve Jobs was cofounder, chairman and CEO of  Apple Inc. However in that year he was booted from the company. Many at the time may have thought that Jobs was done or finished. But by 1997 he was de facto chief of Apple Inc. again. In between 1985 and 1997 he had started another firm, NeXT, and acquired the computer graphics division of Lucasfilm which he spun off as Pixar. After returning to Apple in 1996 he is credited with helping engineer the turnaround of Apple and creating new products and innovations that made it the most valuable publicly traded company in 2011. Jobs must have been exposed to an innumerable number of risks. Many of them were likely negative but several were positive or upside risks.

          Next we will look at government and risk perception and some final thoughts.

What is your risk level (part 2)

Is your gut leading you astray or is it your salvation

             In this part we will look a little further at risk as it relates to making decisions and at some thoughts on the perception of risk. Risk can have an empirical basis, originating in or based on observation and testing or it can have what I will call a theoretical basis, based on guess work or perception. Assume you are an adult Scout leader out camping and want to build a fire. You know that the closer you get to the fire the warmer you get and if you stand in it there is a strong likelihood of being burned. You decide to sit near the fire but not in it and enjoy the warmth and light and also minimize the risk of falling in and getting burned. Now assume you are 20 years younger, a Boy Scout and with other scouts. Your scoutmaster has just told you not to play around the fire because you may get burned. You immediately reason with yourself that you have never fallen into a fire, been burned nor seen your friends suffer burns from a fire. Therefore you conclude that while it may get warmer as you get closer to the fire you will not get burned. So you and several of your fellow scouts decide to play a game of tag around the fire because there is plenty of light and it is easy to see one another plus as an added enjoyment it’s fun to jump over the flames as you try to catch your companions. The scoutmaster visibly ages and suggests that tag should be played somewhere else, not around the fire. It just doesn’t make any sense to you as a scout, why would you want to play anywhere else other than around the fire. Everything is completely under control. What is your risk level as an adult leader and as a Scout? How does your perception of risk change with additional observations, experience or more data?


RMS Titanic

         An additional factor relating to empirical risk relates to a false sense of security from limited observations or results. Although at the time, the observations or results may have seemed complete and conclusive. Nassim Nicholas Taleb in his book, The Black Swan – The Impact of the Highly Improbable has the following quote on page 42, “But in all my experience, I have never been in any accident… of any sort worth speaking about. I have seen but one vessel in distress in all my years at sea. I never saw a wreck and never have been wrecked nor was I ever  in any predicament that threatened to end in disaster of any sort.” E.J. Smith, 1907 Captain, RMS Titanic. Risk can be hidden, missed or not understood but that does not mean it is any less real. What we perceive as the level of risk may or may not be all inclusive or even sufficient to allow for a reasonable analysis. Look back to the financial crisis of 2008 and the collapse of home prices. Most thought that home prices would not only keep increasing but more importantly would not fall. Many individuals planned for the risk of home prices not increasing. The hidden risk was in not fully weighing the impact of the possibility of decreased prices. Or like our good Captain, the risk of an iceberg that could pierce several watertight compartments on a ship.
             Risk then has many facets. Are you comfortable with not only what you may know but that you likely don't know something important.

What is your risk level (part 1) update

             Let’s try a thought experiment. Suppose you have an opportunity to make $1,000 by investing in a pool. However it costs $250 to participate in the opportunity. Let’s further suppose that the likelihood of making $1,000 is one-in-four times that you participate. Each time you participate you will lose your  initial participation fee of $250. Would you participate in this investment opportunity? If you knew that once in every four times you participate you will make $1,000 would you try. What if you thought that you might be successful on one of the first three times you participate? You may be from $250 to $750  ahead. You could then stop investing and take your increase. From a statistical perspective you would be indifferent on your chances of recouping your costs. You know that regardless of what happens, you can recoup your funds if you participate four times, assuming that the investment opportunity is really as you are told.  However how would you react if you had an investment opportunity that would return $5,000 one in every four times you participate but the participation fee is now $3,000. How do you feel about participating now? If you are not successful  the first time you invest you will lose $3,000 but if you invest again and the investment is successful you will have only lost $1,000 ($3,000 cost x 2 less $5,000 payout). But if you are unsuccessful you will have lost $6,000. Do you take your $3,000 loss or try to reduce your lose by investing in the pool the second time. Of course if your investment is successful on the first investment you have $2,000 in net funds over your initial cost.
              Now assume that instead of $1,000 as the potential investment earnings it is $1,000,000 and the cost of investing is $250,000. How do you feel about your investment earnings? Do you feel a bit more reluctance? Realize that the actual statistical odds have not changed but you may not feel as comfortable about this investment because you can’t afford to have to pay the cost more than once. Risk can relate to financial, economic, emotional, physical or mental situations. At what point are you uncomfortable with the level of risk in a particular situation? Or in other words, what is your risk level, are you risk adverse or risk tolerant?

             In the financial world advisors will suggest that you invest your money in a mixture of stocks and bonds. This is to spread your financial risk. You don’t suffer a devastating loss as the stock market falls but you don’t get the full benefit as it climbs. You hope that you get some positive benefit but it will be less than the possible maximum. There are ways to potentially blunt the impact of market gyrations. As in all situations, solutions can be complex or simple, wildly profitable or financially devastating or even breakeven (and you have potentially been on an emotional rollercoaster for no real benefit).
             In world building, the development of backstories, or story lines there is an opportunity to add depth to characters, groups, societies or races by developing and incorporating risk tolerance (or lack of tolerance) or risk reaction components. Characters or groups don’t usually weigh the odds of an action with a mathematical formula but they could subconsciously be influenced about how they perceive risk. The level of risk a character may be willing to assume will affect their reaction to situations. Is a character a rogue with a devil may care attitude (risk taker) or are they cautious and unwilling to expose themselves to danger (risk adverse). Will a risk adverse character get trapped by their failure to act or saved by their caution. As you consider character development consider the risk reactions for that character. How will they react based on their risk aversion or risk tolerance? How might they stay consistent, what would cause them to change their willingness to assume or shun risk. How or why might their risk reaction change. You can ask similar questions of groups, societies and races.