What is Risk and How to Measure It

What is Risk - sweat your assets

Risk is a concept that plays a critical role in many areas of our lives. Understanding risk is essential to making effective choices, whether discussing financial investments, business decisions, or personal safety.

While risk is part of any human endeavor, business and investment fields have devoted extra attention to the subject due to the ancestral fear of losing money.

Like with any human emotion, fear can play and trick us.  It is possible to either see risks everywhere or don’t correctly recognize and measure them at all.

In this article, I will explore what risk is, how it is measured, and how you can use that measurement to make better decisions.

 

What is Risk?

Risk touches on the most profound aspects of psychology, mathematics, statistics, and history. The ability to define what may happen in the future and choose alternatives lies at the heart of human desires.

The key elements that drive modern economies, projects, businesses, and investments are the ability to understand risk, build an appetite to accept and manage some levels of risk and make a forward-thinking decision.

However, the risk is studied and managed under different disciplines, often accentuating different features worth mentioning. There are different types of risks, including financial, business, environmental, and personal.

Peter Bernstein, the Dean of Risk Analysis and author of Against the Gods: A Remarkable Story of Risk, said:

Risk means the chance of being wrong – not always in an adverse direction, but always in a direction different from what we expected.

The concept of risk implies the understanding that nothing is entirely predictable or determined.

Anytime you plan and take action, it is important to acknowledge there is no linearity between Inputs and Outputs because unexpected outcomes occur.

As Professor Elroy Dimson said,

“Risk means more things can happen than will happen.” It is not standard deviation. It is not variability. It is this sense that the future events are highly variable and unknowable that gives us the best sense for risk.

However, there are rational ways to be prepared, make informed decisions, calculate the odds of positive and negative events, and mitigate negative ones.

Ultimately, risk is part and parcel of any event or decision. In fact, “there is the risk you cannot afford to take, and there is the risk you cannot afford not to take.” (Peter Drucker).

So, let’s look at some concepts – from different disciplines – associated with Risk that will help better understand it: Issue, Vulnerability, Threat, Uncertainty, Opportunity, and Returns.

Risk, Issue, Problem, and…Situation

Risk is an element primarily connected to future events. For instance, any adverse event, obstacle, or challenge currently happening right now is technically an issue or a problem, or even “a situation.” Still, it is not a risk because risk only relates to possible future events or scenarios.

Thread, Vulnerability and Risk

These terms are frequently used together. The best way to look at them is as a spectrum:

1) Vulnerability exposes you to a thread. Vulnerability is a weakness, flaw, or another shortcoming in your ecosystem, organization, or process.

2) A thread is an adverse (negative) event that takes advantage of a vulnerability. It is strongly related to conditions and opportunities.

3) Risk is the potential of a negative (harmful) event, including loss and damage, when the thread does occur. It can further be described – and measured – as the probable frequency and probable magnitude of loss.

Bottom line: accurately assessing threads and identifying vulnerabilities is critical to understanding the risk. Threats may exist, but if there are no vulnerabilities (weak spots), then there is limited risk.

Risk and Uncertainty

In common usage, the word risk and uncertainty refer to similar situations in which some aspect of the future cannot be foreseen. In some fields, risk denotes a probability of something terrible happening, while uncertainty does not necessarily imply a value judgment or ranking of the possible outcomes.

Still, in economics, the definition of risk and uncertainty is more pronounced:

  • Risk is present when future events occur with measurable probability
  • Uncertainty is present when the likelihood of future events is indefinite or incalculable

Risk and Volatility in Markets

Risk and Volatility are crucial concepts for investors and traders in financial markets.  They are often used interchangeably. For Peter Bernstein:

“Volatility is often a symptom of risk, but it is not a risk in and of itself. Volatility obscures the future but does not necessarily determine the future”.

  • Market Risk is the possibility/likelihood of losing money. It is mainly related to system risk when the whole market loses money due to external crises and events (COVID, Wars, etc.).
  • Volatility (1): Volatility is a mathematical formula, an “easily” measurable, comparable metric created statistically from past prices of securities. It reduces something very complex down to a single number. Its apparent simplicity makes it the preferred risk measure in the asset management industry.
  • Volatility (2): The Chicago Board Options Exchange (CBOE) measures stock volatility by tracking options on the S&P 500 index. The official name for this measurement is the CBOE Volatility Index (VIX), nicknamed the “fear index” because, when the VIX reading is high, stock markets are usually in turmoil. Volatility is present to some degree in the price movements of all securities – however, some securities and asset classes are inherently more volatile than others.
  • Volatility (3): Traders sometimes measure volatility using the Greek letter beta (β). Beta measures the overall volatility of a security’s returns against a benchmark like the S&P 500.

Risk and Opportunity

Studying risk requires introducing the relationship between risks and opportunities. There is a strong interconnection between the two. Under any human endeavor, seeking opportunities requires embracing a certain level of risk.

  1. Risk and opportunity could be seen in a binary way, as two opposite sides of the same coin or
  2. We could refer to opportunity and risk as endeavors with different degrees of impact in the future, where a risk with a negative impact is a threat or loss, whereas a risk with a positive impact is an opportunity.

Upside Risk and Down Side Risk

Along the line of Risk and Opportunity, in the investment field, it is common to think about Risk and its positive or negative outcomes relying on two concepts:

  • “Upside risk” focuses on uncertain positive returns rather than negative returns. For this reason, while a measure of unpredictability of the extent of gains, upside risk is not a “risk” in the sense of a possibility of adverse outcomes.
  • “Downside risk”: the financial risk associated with losses. It is the risk of the actual return being below the expected return or the uncertainty about the magnitude of that difference.

The comparison of upside to downside risk is necessary because modern portfolio theory measures risk in terms of the standard deviation of asset returns, which treats both positive and negative deviations from expected returns as risk. The Capital Asset Pricing Model (CAPM) assumes that upside and downside beta are the same. However, they are seldom the same: security distributions are non-normal and non-symmetrical.

Since investment returns tend to have a non-normal distribution, there are different probabilities for losses than gains. The probability of losses is reflected in the downside risk of an investment or the lower portion of the distribution of returns. It is crucial not simply to rely upon the CAPM but rather to distinguish between the downside risk, which is the risk concerning the extent of losses, and upside risk, or risk concerning the extent of gains.

Risk and Returns

In the business and investment sector, the risk is strongly related to returns, under the general assumption that the higher the level of investment risk, the higher the potential return. Or – the other way around – to accept higher risks, it is necessary to expect or demand higher returns (the Risk-Return tradeoff). The successful Investor and author Howard Marks clarified this point in this short video tutorial (Risk Revisited Again).

 

Risk Revisited Again, by Howard Marks

The bottom line is that in any sustainable business initiative where we seek returns, embracing and managing risk is necessary. Risk is not something to be avoided tout-court, but measured and managed.

 

Real Risk vs. Perceived Risk

American Investor Bill Miller put it bluntly: Real Risk and Perceived Risk are two different things. And that’s where people get into trouble because they perceive the risk to be high when [market] prices are low, and they perceive the risk to be low when [market] prices are high.

 

Measuring Risk: Impact x Likelihood

One way to think about risk as a negative event can be done in terms of two components: impact (consequences) and likelihood.

  • (Negative) Impact refers to the severity of the harm or loss resulting from a particular event or action.
  • Likelihood refers to the probability that the event or action will occur.

For example, if you are considering investing in a particular stock, the impact of that investment failing might be the loss of your entire investment. The likelihood of that happening might be relatively low, say 5%. Therefore, the risk associated with that investment is relatively low.

Many methods for measuring risk include statistical analysis, expert opinion, and historical data analysis. Let’s have a look at some tools and methods.

The Risk Matrix

 A Risk Matrix is one of the most common methods for measuring risk. A risk matrix is a grid that combines the impact and likelihood of a particular event or action to produce a risk score. The score is usually expressed as a number or color, with higher scores indicating a higher level of risk.

To use and build a risk matrix, you need to:

1. Identify the potential risks associated with a particular action or event.

2. Assess the impact of each risk on a scale of, for example, low, medium, or high.

3. Evaluate the likelihood of each risk occurring on a scale of, for example, low, medium, or high. 

4. Combine the impact and likelihood assessments to produce a risk score.

For example, imagine you are considering launching a new product in a business situation. One of the risks associated with this action might be that the product does not sell well, resulting in a loss of revenue.

The impact of this risk might be assessed as high, as it could have a significant impact on the company’s financial performance. The likelihood of the risk occurring might be assessed as medium, as there is some uncertainty around the product’s market demand.

Combining these assessments would produce a risk score, indicating a level of risk.

Event (x): Likelihood / ImpactLow Impact (1 point)Moderate Impact (2 points)High Impact (3 points)
Low Likelihood (1 Point)Low Risk (1 * 1 = 1 Point)
Moderate Likelihood (2 Points)Moderate Risk (2*2=4)
High Likelihood (3 Points)High Risk (3 * 3 = 9)

 

In addition to the risk matrix, many other methods can be used to measure risk. Some of these methods include:

The Monte Carlo simulation

This method uses mathematical models to simulate the impact of different scenarios and events. It can be used to estimate the likelihood of various outcomes and assess the potential impact of each outcome. It can be done in Excel (I liked this tutorial). 

The Decision Trees

This method involves creating a visual representation of different possible outcomes and the probabilities associated with each outcome. It can evaluate the risks and benefits of different decisions and identify the most favorable option. It can be easily done in Word, PowerPoint, or Excel (I liked this Excel Tutorial). 

The Sensitivity Analysis (What If)

This method involves testing how different variables and assumptions affect the outcome of a decision or event. It can be used to identify the most critical factors contributing to risk and assess the potential impact of changes in those factors. It can be quickly done in Excel. 

Historical Data Analysis

This method involves analyzing past events and data to identify patterns and trends relevant to current or future risks. It can be used to identify potential risks and assess the likelihood of those risks occurring. 

Expert Opinion

This method involves consulting with experts in a particular field to assess the potential risks of an event or decision. It can be helpful when there is limited or “noisy” data or when the risks are complex or difficult to quantify.

Conclusion

Risk is an essential concept critical in many areas of our lives. By understanding and measuring risk in its different forms, you can take steps to mitigate or manage it to achieve the desired goals.

Overall, the choice of risk measurement method will depend on the specific situation and the available data and resources. Using a method appropriate for the situation is essential and provides accurate and reliable results. 

While I love quantitative and qualitative analysis tools, whenever data involves human interactions and future events, the underlying method is more an art than a science.

That’s why good judgment (wisdom) is a critical aspect of Risk assessment and management. 

If you like this article #139 on Risk, don’t miss other Financial Wisdom. Consider signing up for my monthly newsletter, check out my past articles in my Archive, YouTube videos, and Audio Podcasts.

 

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