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What is Risk?

This whole thing called ‘RISK’, if at all can be explained, I think depends on our beliefs.   I do respect everyone’s journey and how the beliefs get built.  I might be sounding arrogant or intuitive but I shall try to put forth my thoughts, just MY thoughts.  There is a probability I could be wrong.  Well, the pursuit is not perfection anyway.  So, here is what I think….

In pursuit of understanding my own self, I went ahead and asked google which part of my brain assesses risk.  Here is what google said.

Assessing and reacting to risk is one of the most important things a living creature has to deal with, and there’s a very primitive part of the brain that has that job. It’s the amygdala, and it sits right above the brainstem, in what’s called the medial temporal lobe.

Interesting! When we already have a part of our body meant to do the job of risk assessment then what makes it so hard to understand?

Statistically, “Risk” refers to the probability of occurrence of an event or outcome. Statistically the term “odds” is often used instead of risk.

Literal definition of Risk  [dictionary]: The chance of injury, damage or loss; dangerous chance; hazard, or the chance of loss; the degree of probability of loss.

The psychology of risk is the study and understanding of the mental processes underlying our responses to risky situations, the recognition of a risk’s impact, and the development of frameworks that can help individuals make sound judgments in the face of risk

In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision. In general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks.

What Is Risk Management?

In the financial world, risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management occurs when an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment, such as a moral hazard, and then takes the appropriate action (or inaction) given the fund’s investment objectives and risk tolerance.

If I can take the liberty of generalizing risk, in simple terms this is the impact associated with something unknown.  The fact that it is unknown could bring ‘fear’.  Some level of fear is good; as that leads to a better understanding if we give ourselves time and learn. 

Let us get into the world of trading now.  Why do traders lose money inspite of knowing  the stop loss (the level at which one has to book the loss and exit the trade).  It could be because Stop Loss was part of the plan but was not executed.  Fact is; if someone is asked to leave Rs. 2000 on the road and never think about it, most people will feel this is arrogance or disrespect.  Then, why do we do that in trading?  It is because of the MIND.  We cannot accept that losing is part of the game.  We start a new loop of thinking called “hope”.  This in finance is NO good.  In endurance sports it could work but not in stock market.  By hoping to recover the loss where stop loss was not honoured is like waking up half day late and expecting you have more than 24 hours to recover the lost time.  What is gone is gone, time never comes back but lost money CAN, provided we are ready to learn from the mistakes and give it time to sink into our belief system

Two of the biggest risks are 1) Not taking any risk 2) Not knowing what we are doing.  To mitigate these issues I would say we can take calculated risks.  What do I mean by that? Well, if we know what we are doing, but do not know the extent of loss or damage, we can probably take the risk with a pre-defined plan on when to stop.  This will make it clear and we wound not worry much about the outcome.  Trying and failing is better than not trying at all.  We may experience some loss but what we learn in the process is worth a lifetime.  Problem comes not because of loss but because of emotions attached to the outcome.  Probably because we have not learnt how to forgive ourselves completely.  If this is not controlled at some point it could lead to a circle of mistakes which could get us unhealthy or make life miserable. 

Actually our financial or any life decision is based on our belief which gets built from the day we land on planet earth.  We learn about places, people, faith, religion, logic etc and become a unique person.  How is it possible that two kids from the same parents have different belief systems.  Beyond a certain point we are what our unique experiences make us.

Case 1: Fearing the financial meltdown during March 2020 (pandemic) if people had withdrawn all the investments and put it into savings account then return in 1 year would be as below.

ParametersSavings Bank
Investment             100,000
Rate of return6%
time (year)1
Return per annum                 6,000

Table below shows various banks with their interest per annum on savings account.  Fixed deposit is not very different either. (https://www.wishfin.com/savings-account-interest-rates/#icici-bank)

(source: https://www.wishfin.com/fixed-deposit-interest-rates/)

Case 2: If the same amount was invested into ETFs rather than Savings account it would have been as follows:

Those who do not have time to analyse can invest in ETFs as a systematic investment frequently.  May be a certain amount each month irrespective of market condition.  However, please make sure the amount invested is not for immediate requirement. As ETFs are subject to market risk these instruments are best used for long term.  (to know more about ETF read: http://peacefulinvestors.com/exchange-traded-funds-etf/)

ParametersETF
Investment     100,000
Rate of return60%
time (year)1
Return per annum       60,000

Table below shows return on ETF for past 1 year (source: moneycontrol)

The return on ETF is obviously higher; however this does not happen every year.  The point here is to stay invested rather than time the market based on our risk or belief.  Discipline and patience have no shortcuts but only benefits.

Happy investing, stay safe and help people in need.


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Post Author: rashmi