Abandoning Predictions & Embracing Risk (CLMonthly-003)

The future is unpredictable.  We cannot predict any future event with 100% certainty, although we can use past experiences and future expectations to infer potential outcomes.  Even this has some risk involved since we cannot estimate all possible results in a world full of unexpected and random events.  Most of us disregard the inherent uncertainty involved in the decisions we make and instead choose to believe that uncertain events are predictable.  We see this in financial markets all the time when amateur investors think they can accurately predict future stock prices.  Any unbiased and rational person would agree that this is a prime example of an uncertain outcome, yet many of us foolishly believe we can predict it with certainty.  

The essence of investment management is the management of risks, not the management of returns.

Benjamin Graham

If something is unpredictable, does this mean we should avoid it?  Not at all.  We should instead be welcoming it with open arms.  Once we accept that we cannot predict the future, we can make better decisions in business, investing, and anything else – which is where risk management comes in.  The entire premise of risk management revolves around knowing that most outcomes are out of our control, but by strategically managing our risk exposures, we can favourably affect the probability of beneficial outcomes occurring for us. 

Risk management goes beyond business and investing. It’s fundamental to the decision-making process of all humans.  Contrary to popular belief, risk management is not risk aversion. It’s about strategically managing your portfolio of risk exposures and deciding when, how, and how much to spend.  Just like with money, reckless spending of risk could result in unmanageable debt burdens, overwhelming failures, and other undesirable consequences.  That said, merely hoarding risk units without spending or investing them in potential return-generating opportunities will severely limit the ability of an individual or a business to grow, and ultimately maximize the returns on their risk.  Risk management isn’t static, however.  It continually changes based on circumstances.  Like their investment portfolios, the optimal risk portfolio for a student will drastically differ from that of a retired senior based on their different stages of life.

If you are not willing to risk the unusual, you will have to settle for the ordinary.

Jim Rohn

But before we can manage risk, we must understand it.  Risk is one of the most valuable assets any person, business, or other entity can possess.  You can buy anything with risk if you have enough to spend.  The more you are willing to pay, the more potential returns you can buy.  Unlike many other tangible assets, its value almost always holds. It’s rare to see a high risk-low reward or low risk—high reward opportunity.  When they do pop up, they quickly disappear.  The former would become obsolete from lack of demand, and the latter would be capitalized on by arbitrageurs before immediately disappearing.  For the most part, there is no free lunch when it comes to risk.

Strategic and intelligent thinking about risk can make a big difference in the decision-making process for businesses and individuals alike.  Risk management involves actively controlling risk to achieve our goals.  Once we have a clear understanding of our risk portfolio, then we can decide how to maximize the returns on a risk-adjusted basis.  But it all starts with abandoning the fallacy of predictions and embracing the power of risk management.

If you don’t invest in risk management, it doesn’t matter what business you’re in; it’s a risky business.

Gary Cohn

Free Your Mind.

CL

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.