Friday, May 7, 2010

Understanding Personal Financial Risk

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. If you dive into investment textbooks you can find 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.

For individuals all the mathematical equations in the world miss a very large point about real risk. You are only one person, and you only get one result, not a array of possible results.

Let’s take a simple example of what I mean by real risk. You are contemplating investing in a stock that in one year will be worth either $0 or 1,000 times as much as it is today with a return of your investment to boot. There is a 50/50 chance of each result and to make this bet you have to put up everything you own, but no more than $10 million. A math guy would tell you that your expected rate of return is 500%.

I don’t know about you, but I’m not worth $10 million, so I would be investing everything I had. I’m retired and if I lost it all, I would 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 if I lose I’m wiped out and 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 really as represented.) While he wouldn’t want to lose $10 million, the loss is less than .02% of his reported 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 in the future, 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 gladly risk all of it (say $5,000) to earn $2,500,000.

When we look at financial risk as an individual, we can’t just look at it as a financial wonk would. We have to consider what it means to us if the investment pays off and what happens if it doesn’t.

In the next few posts we’ll consider some specific aspects where this perspective is helpful in making personal financial decisions.

~ Jim

1 Forbes Magazine 2010

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