A Long Look at Risk: Avoid making the wrong choices at precisely the wrong moments.

A Long Look at Risk 

Most of us aren’t honest with ourselves about how much investment risk we can handle. Even worse, we tend to change our minds at market tops and bottoms, making the wrong choices at precisely the wrong moments.

An accurate assessment of risk is important. But you can view risk in many ways.

RISK CAPACITY:  David B. Jacobs of Pathfinder Financial Services in Kailua, Hawaii, usually starts with risk capacity. Young people have a great deal of risk capacity, since they have their whole career ahead of them to make up for any mistakes. A football player might have much less risk capacity, since he could have only a few years of high earnings. And some retirees have plenty of risk capacity, if they have a solid pension.

RISK NEED:  Then Mr. Jacobs moves to risk need. Need is driven by goals.Someone with no heirs and $20 million in municipal bonds might not care so much about significantly growing the portfolio. But if that person suddenly becomes passionate about a cause, he or she may want to double that amount in a decade to create an endowment or put up a building.

RISK TOLERANCE:  Only then does risk tolerance become a factor. “You have to help people visualize what the risk means,” Mr. Jacobs said. “If a year from now, your $1 million is $700,000, how would it change your life? Does that mean you can’t go visit your grandchildren? I’m trying to dig down and make people think of exactly what their day would be like.”

To measure risk we have to use probability

To manage risk, we have to be able to measure it, and to measure risk we have to use probability.  Probability is the quantitative language of risk and uncertainty.

The probability of an outcome is a number expressing the likelihood of it actually happening.  It can be a number between 0 and 1, where 0 indicates an impossible outcome and 1 a certain one, or it can be expressed as a percentage (a number between 0 and 100).

In some situations, probability is objective and factual.  For example, the probability of calling the toss of a coin correctly is 0.5 or 50%.  However, tossing a coin is a very simple event.  It is easy to use past experience and real-world knowledge to assess the probability of a 'heads' or 'tails' outcome. 

As situations become more complex, it becomes progressively more difficult to be objective about probabilities; they become more subjective.  Business situations are extremely complex, and therefore the probabilities involved are highly subjective. 

Because the decisions we make in business are so important, it is vital to try and pin down the probabilities involved, even though it may be impossible to achieve complete objectivity.  The more precision we can bring to the situation, the firmer the foundation on which we make a decision.  To move towards precision, we need to look at subjective probabilities.

How To Deal With Risk

How To Deal With Risk

People often do not properly assess the potential rewards for taking a risk. Nor do they focus on how well the risks and rewards match.

Your company faced a potential growth initiative that offers both high risk and high reward.


Ask yourself:

1. If you take this high risk and fail, will you lose the ranch?

If yes, you may not want to go ahead. If the risk is not of the bet-the-company type, then ask,

2. If you fail, will it put your company at a severe disadvantage?

Sometimes it is worth betting on a new initiative or idea, but you always want to have a handle on what you are up against. You also want to know how to reduce risk, shape it and manage it.


Convinced the risk is worth taking, you then drill down farther and decide whether the project is too risky, given the other risks in your company's investment portfolio.

Ask again and decide:

3. Would the inclusion of this project push the company over the edge?

If yes, and should you still decide to take the risk ahead, ask,

4. Would sharing the risk by an alliance be an acceptable option?