Knowing others is intelligence; knowing yourself is true wisdom.
Mastering others is strength; mastering yourself is true power —
Lao Tzu, Tao Te Ching
All growth comes at a price. A price, all of us know by the word “risk”. However, over the generations, one of the least developed parts of our intelligence is “risk intelligence”. Risk intelligence directly stems from our own lack of understanding of our own capabilities. A bias we call over or under estimating our true strengths and more importantly, our weaknesses. This might sound counter intuitive considering the fact that one would think risk stems from our lesser understanding of external forces. However, the ability of humans to reason is the sole reason we behave as unreasonable parasites on a planet we call home.
The way to think about our situation is: how many external forces can we actually control even though we think we have general control over most things? I am not saying that all control is an illusion. I am saying that focusing on knowing our inner selves and on understanding risk intimately, we can grow healthily with less stress than just winging it. This article delves deeper into our simple misunderstandings about risk and what we can do to overcome some of them.
What Is Risk
Etymologically, the word risk is a mid 17th century word derived from the French word “risqué” or Italian word ‘risco’ meaning danger. Put simply, risk means a situation where things could go wrong. It could lead to a financial or personal loss.
Put more broadly, the word risk literally begins with life itself and indicates the fragility of life at every step. From being in an accident to losing savings, there are a million scenarios that originate from life itself. A dear friend once told me:
The number one cause of death is life itself
However, it’s not as moribund as it sounds. In a positive vein, the word risk tells us to have a backup plan always just in case things to wrong. Another word for a backup plan which may or may not cover the loss completely is a hedge. The word hedge is usually used in terms of financial literature. However, it can apply to any kind of risk. For instance, life insurance is an hedge in case something happens to a loved one. It may or may not cover the loss completely. Of course, the biggest loss in this case is non monetary.
Risk can also be viewed from a time and liquidity point of view. For instance, Sam may own a condo but if the market is illiquid, he may not be able to sell it on time when he needs the money.
When an entrepreneur says he doesn’t have enough capital to launch a business, he is usually saying that he has no appetite to take a risk.
In the business world, there is a myriad array of risks that a company faces. Broadly speaking, the risks partially or completely under the control of a business are known as unsystematic risk while the risk which emerges from the environment in which the business operates (eg market risk) is called systematic risk. A hedge against an unsystematic risk that the business is dependent on few clients can be minimized by ‘diversifying’ the list of clients. Put simply, having more clients is a good way of reducing concentration of risk in a few clients.
In market terminology, everyone participating in the market face ‘systematic risk’ which is simply not controllable or manageable. On the other hand, ‘unsystematic risk’ is the risk that arises from holding a particular asset e.g. Apple stock, gold, Dollars etc. This risk can be managed or mitigated by diversifying or holding an asset that behaves in an opposite way to similar forces.
Risk has an intimate connection with gambling. However, the history of risk management began with the insurance industry for pricing their products i.e. to determine premiums to be paid by policy holders. Following big scandals in financial accounting in conglomerates such as Enron, WorldCom and Tyco, the Sarbanes Oxley Act was enacted to strengthen controls and oversight. Consequently, an Enterprise Risk Management (ERM) framework was laid out by the Committee of Sponsoring Organizations (COSO). The framework has eight key components and is used by most large organizations to manage risk.
The real troubles in your life are apt to be things that
never crossed your worried mind; the kind that blindside you at 4pm on some idle Tuesday — Baz Luhrmann — Everybody’s Free (to Wear Sunscreen)
Put simply, Risk = Consequence * Probability. In George Patton’s words:
Take calculated risks. That is quite different from being rash.
However, the UK philosopher and psychologist Dylan Evans defines it as “a special kind of intelligence for thinking about risk and uncertainty”. He has coined a special quotient called “Risk Quotient” to supplement EQ and IQ. The risk you face depends on your position. If you are a businessman that exports things, foreign currency fluctuations, country risk, political risk can affect your business. If you are a stock market investor, market volatility poses a risk. If you are a bond investor, interest rate fluctuations pose a risk. In short, anything that is not in your control poses a risk. There is financial risk and there are a lot of other risks that are hard to conceive because they are non-monetary and appear out of the blue. This is where Dylan’s concept of risk intelligence comes into play.
One of the greatest book I ever read was Reminiscences of a Stock Operator — a 1923 roman à clef by American author Edwin Lefèvre which is the thinly disguised biography of Jesse Lauriston Livermore. Jesse Livermore becomes a successful stock operator, loses everything and rises back again. The important lesson to learn is that it’s hard to judge the wisdom of the crowd i.e. time the markets consistently. All of us will be wrong at least once and maybe perennially.
Risk should also not be confused with volatility. Volatility is how rapidly or severely the price of an investment may change, while risk is the probability that an investment will result in permanent loss of capital.
Risk Is Absolutely Personal
As per Wikipedia, ISO 31000 is a family of standards relating to risk management codified by the International Organization for Standardization. The purpose of ISO 31000:2009 is to provide principles and generic guidelines on risk management. Although the standard lays down risk management from a corporate perspective, the principles are the same. The only other additional risk is unforeseen risk.
If you look at the list of human biases, its almost endless. Everyone has their own blind sides. The best way to recognize them are to often ask other people to identify them for you. Perhaps, a close friend. The next step is not let the biases control you which is easier said than done. It does not mean putting an exact number to the probability of the loss. It just means getting better at recognizing our blind sides and not allowing them to interfere with our decision making process. It is just like meditation which gets better with practice.
If you think too much about risk, you risk stasis. If you think too little, you are exposing yourself to different types of destruction of value. The only way to get better at managing risk is actually by practice i.e. it’s hard to learn from other peoples mistakes if we are prone to make a different set of mistakes which is why I leave you with these words by Giorgio Armani:
This is the problem with the world today: Nobody wants to take risks, to risk being themselves.