Tuesday, 22 April 2014

Understanding Risk - Risk explained to a sixteen year old

By Girish Menon

Risk is the consequence one has to suffer when the outcome of an event is not what you expected or have invested in.

For e.g. as a GCSE student you have invested in getting the grades required by the sixth form college that you wish to go to.

The GCSE exam therefore is the event.

From an individual's point of view this event has only two possible outcome viz. you get the grades or you don't.

Your investment is time, money and effort in order to get the desired outcome.

The risk is what you will have lost when despite all your investment you did not get the desired grades and hence you are not able to do what you had wanted to do.

From a mathematical point of view since there are only two possible outcomes one could say that the probability of either outcome is 0.5.

Your investment with spending time studying, taking tuitions, buying books.... are to lower the probability to failure to as low a figure as possible.

Can you lower the probability of failure to 0? Yes, by invoking the ceteris paribus assumption. If all 'other factors' that affect a student's ability to take an exam are constant, then a student who has studied all the topics and solved past papers will not fail.

Else, some or all the 'other factors' may conspire to bring about a result that the student may not desire. It is impossible to list all the 'other factors' and hence one is unable to control them. Hence, the exam performance of even a hitherto good student remains uncertain.

If the above example, with only two possible outcomes, shows the uncertainty and unpredictability  in the exam results of a diligent student then one shudders to think about other events where all the outcomes possible cannot be identified.

Let's move to study the English Premier League. Here, each team plays 38 matches and each match can have only three outcomes. When one considers picking a winner  of the league one could look at the teams, the manager etc. But, 'other factors' such as injury to key players, the referee...... may scupper the best laid plans.

When one looks at investing in the shares of a company one may study its books of accounts. Assuming that these books are accurate, this information may be inadequate because it is information from the past and the firm which made a huge killing last season may now be facing turbulent conditions of which you an outside investor maybe unaware of. The 'other factors' that may impinge on a firm's performance will include the behaviour of the staff inside the firm, behaviour of other firms, the government's policies and even global events.

Yet, as a risk underwriter one has to take into account all of these factors, quantify each factor based on its importance and likelihood of happening and then estimate the risk of failure. The key thing to remember is that the quantitative value that you have given each factor is at best only a rough estimate and could be wrong. Which is why every risk underwriter follows Keynes' dictum, 'When the facts change, I change my mind'. George Soros, the celebrated investor, has been rumoured to say no to an investment decision that he may have approved only a few hours ago.

Even if Keynes and Soros may have changed their minds on receipt of new information I am willing to bet that their investment record will show many wrong decisions.

So if the risk in investment decisions itself cannot be accurately predicted imagine the dilemma a politician makes when he decides to take his nation to war.

Hence the best way sportsmen, businessmen and politicians overcome the uncertainty of decision making is by posturing. Pretending that you are the best and everything is within your control. They hope that this will scare away the challengers and doubters and victory becomes a self fulfilling prophecy. Alas! It unfortunately does not work every time either. 

(The author is a lecturer in economics.)

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