Understanding Risk

Risk means uncertainty about the result of some action or situation. In financial terms risk is the possibility that the actual return from an investment will differ from the expected return. All investments carry a degree of risk, since investment return is not guaranteed.

People generally understand that the greater the risk one takes in making an investment, the greater the return has the potential to be if the investment succeeds. On the other hand, the risk also involves the possibility of losing all of the monies invested.

Understanding Risk

Prediction and Probability

We usually talk about risk when there is a known chance or possibility of loss:

Will I realise a high profit from my investment?
Will I lose my savings due to financial instability of my bank?

People usually make financial decisions based on a perceived/subjective spectrum of probability of different consequences.

Some situations have a higher chance of happening (higher probability) and risk can be reduced:

You know your bank is new on the market and that it invests its free capital in volatile stock funds. Even though it offers high profit, you probably won’t put all your savings on their accounts. You feel that there is a higher chance that the bank might go bankrupt for its unsafe investments and do not want to risk losing all your money.

On the other hand, some situations have a lower probability about them, though not impossible, and you can only try to lower the possibility that undesirable consequences will occur:

You invested a significant amount of your savings in a conservative deposit fund operated by a very stable bank that has branches all over EU. An unexpected/unpredictable situation occurs when the banks’ officials allow bad investments that deeply affect the bank’s cash flow. You will not get any dividends that year.

Risky behaviour!

In economic theory, we recognise three different types of personalities according to their relationship to risk:

* risk-averse – people who are cautious regarding risk and generally try to avoid it; they prefer low, but certain profit. Given a bet with a 50-50 chance of success or failure, a risk averse person will always refuse the bet and will insist on better than 50-50 odds. How much better than 50-50 odds is a measure of their risk-aversion. It is generally believed that most people are risk-averse, to some degree at least.

* risk-loving – people who seek out risk in the full knowledge that the rewards may be great but also that they take the risk of significant loss. A risk-loving person will always take on a bet with a 50-50 chance of success or failure and will even take it on if the chance of success is less than 50%. How much less than 50-50 is a measure of their degree of risk-loving.

* risk neutral – people who are in-between the above two categories in terms of their attitudes towards risk take risk sometimes. They would be indifferent between taking or not taking a bet with a 50-50 chance of success or failure.

optimism bias is a new concept - people tend to be over-optimistic about the outcome of planned actions.

Sources of risk

We encounter risk in all areas of finance – from saving and investing through paying in different ways, to borrowing. Insurance is probably the most common area to talk about risk but not the only one.

Financial risks come from different sources:

risk of theft, loss or damage of personal property
risk of illness, injury or accident
risk of change in life situation – unemployment, retirement, loss of a partner
risk of liability for damages caused to third persons
risk of identity abuse
risk of payments (over internet, with payment cards)
risk linked to saving and investing.

How can we reduce risk?

by having all the information:
- compare products and make informed choices
- read your offers / contracts / bank statements carefully
- when contracting financial services in foreign countries, make sure you are familiar with local legal system and language

by insuring
- diversify your savings / investment portfolio - by putting money into different investment instruments you ensure that you don’t lose it all at once;
- see factsheet: Insurance for further information

Investment and risk

Everyone who wants to save or invest should ask him/herself the following questions:

Do I prefer high profit?
- If yes, will I be able to bear high risk of loss and low liquidity, or
- do I prefer lower profit and an easy nights sleep?

Making an investment is a trade-off between risk and return.