Risk is incorporated into so many different disciplines from insurance to
engineering to portfolio theory that it should come as no surprise that it is defined in
different ways by each one. It is worth looking at some of the distinctions:
a. Risk versus Probability: While some definitions of risk focus only on the probability
of an event occurring, more comprehensive definitions incorporate both the
probability of the event occurring and the consequences of the event. Thus, the
probability of a severe earthquake may be very small but the consequences are so
catastrophic that it would be categorized as a high-risk event.
b. Risk versus Threat: In some disciplines, a contrast is drawn between risk and a threat.
A threat is a low probability event with very large negative consequences, where
analysts may be unable to assess the probability. A risk, on the other hand, is defined
to be a higher probability event, where there is enough information to make
assessments of both the probability and the consequences.
c. All outcomes versus Negative outcomes: Some definitions of risk tend to focus only
on the downside scenarios, whereas others are more expansive and consider all
variability as risk. The engineering definition of risk is defined as the product of the
probability of an event occurring, that is viewed as undesirable, and an assessment of
the expected harm from the event occurring.
Risk = Probability of an accident * Consequence in lost money/deaths
In contrast, risk in finance is defined in terms of variability of actual returns on an
investment around an expected return, even when those returns represent positive
Risk and Reward
The “no free lunch” mantra has a logical extension. Those who desire large
rewards have to be willing to expose themselves to considerable risk. The link between
risk and return is most visible when making investment choices; stocks are riskier than
bonds, but generate higher returns over long periods. It is less visible but just as
important when making career choices; a job in sales and trading at an investment bank
may be more lucrative than a corporate finance job at a corporation but it does come with
a greater likelihood that you will be laid off if you don’t produce results.
Not surprisingly, therefore, the decisions on how much risk to take and what type
of risks to take are critical to the success of a business. A business that decides to protect
itself against all risk is unlikely to generate much upside for its owners, but a business
that exposes itself to the wrong types of risk may be even worse off, though, since it is
more likely to be damaged than helped by the risk exposure. In short, the essence of good
management is making the right choices when it comes to dealing with different risks.