What if something goes wrong?

Most people are not keen on taking risks. A small faction of people are definitely risk–takers. Whether you are one or the other, the decisions you make often boil down to one ratio: The Risk-return equation.

We spend a lot of time on Return, and a lot of time on ROI, but surprisingly little on Risk – which is the main topic of this segment.

Probably the first thing we should do is define risk. Here’s what the dictionary says: Exposure to the chance of injury or loss. From my perspective, this is a bit narrow. I’d like to widen it to include business risks, financial risks, project, personal – just about everything. And, I’d also like to look at the source of risks, but more on this later.

Let’s start in the world of investments, and examine a concept called “variability of returns”. This concept refers to the fact that most investments oscillate up and down in value. The more frequent the variability, and the more dramatic the swings up or down, the greater the risk that you’ll be exposed to loss. Clearly, the fewer the swings, the “less” risky the investment.

The challenge for investors, is to determine the “risk profile” (or for advisors, the risk profile of their clients), and only invest securities that match. So if you are risk averse, you might purchase a Guaranteed Investment Certificate, which has zero variability. If you can handle risk, you might purchase a number of stocks or mutual funds. Of course, when you do buy the stocks, you’ll want to purchase when their value is at the lowest point of the cycle, and sell when they’re at the peak of the cycle.

Another way to mitigate this type of risk is to hold the security for a longer term: 10-15-20 years. Over time, the shorter-term variability means less and less, especially relative to the longer-term growth of the stock.

Finally, a third strategy to reduce risk is to hold a number of stocks (statisticians will tell you 30+ is the magic number) as this diversification means that any losses with one stock will be cancelled out with the gains in another. With variability cancelled out, then the portfolio is left only with the long-term gains.

Let’s go back to the Guaranteed Investment Certificate – seems like it’s zero-risk? Think again: the GIC has huge inflation risk. Specifically, what happens to the purchasing power of the dollar at the end of the term? If there is inflation, each dollar returned from the GIC are devalued, even though there is a “return” – the interest payment. Contrast this with stocks, where since they represent a real asset, if the value of that asset increases with inflation, then the share price should reflect this.

Several other investment-related risks:

• Liquidity risk: The possibility that you cannot sell your shares when you would want to. For example, when there are no buyers.
• Credit risk: The possibility that a debtor doesn’t meet their debt repayment obligations.
• Currency risk: The possibility that while the investment is doing well, the exchange rates move in the wrong direction, and the value of your investment slides.

This last risk – currency risk – is something that happens all of the time with businesses doing international trade. Let’s say, for example, that you lend a big contract in Euros, selling one million Euro’s worth of your widgets, for delivery in six months. The deal is profitable at today’s exchange rate, but if the dollar/euro exchange rate moves in the wrong direction, you could lose your shirt. Using currency futures and forwards, you can reduce the risk, almost to zero. Essentially, the way it works is that if currency rates swing badly, the value of the financial instruments increase. If the exchange rates move in your favour, then the value of the financial instruments decrease: you’re safe, but at a slight cost of setting up the hedge. From a business perspective, there are many risks:

• Risks that a client doesn’t pay
• Risk of physical damage
• Liability in case of injury
• Liability for negligent business decisions

Each of these (and others) can be addressed in two ways:

(1) To use business process to reduce risk, or (2) To purchase insurance to make you “whole” in case the risk materializes.

For example, to reduce the risk that a client doesn’t pay, a business might do the following:

1. Only sell on credit to customers with good credit scores – credit history.
2. Include clear contact language spelling out payment obligation, and what would happen if payment isn’t made.
3. Invoice in a timely manner, with clear, understandable language.
4. Etc.

The use of insurance to protect against risk materializing, should really be the second strategy – not the first.

And regarding insurance, there are several parts to an insurance contract: premium, the risks, the payment amounts, and the payment conditions. The premium is how much you pay, and is completely dependent on the other three components. The “risks” are what you are insuring against. The payment amount is how much you get if the risk occurs. And the payment conditions are the fine print.

Here’s an example using a “personal” risk. Most homeowners carry insurance on their home, insuring against fire, flood, and several other risks. The payment amount will be capped by the insurance company at the value of the house: you cannot get $3 million insurance for a $600K house. The payment conditions might specify a $1000 deductible on any claim, and may also specify the maximum number of claims per year. Based on this, the insurer will tell you the premium you will need to pay. Lower deductibles will mean higher premium. If you have a fire alarm with monitoring, your premiums may be lower, because houses with alarms can be saved, more so that houses without them.

There are many other types of business risks…

• IT Risks: This refers to the risk of technology being compromised, or data being compromised In the medical world
• Infection Risk: This is the risk that infection will spread to others
• In the project management world, Project Risk: This refers to the risk that a project won’t be delivered on time or on budget

Another observation:  the downside – the risk – in large enterprises/ projects/ investments – is inherently larger than for smaller initiatives, for two reasons:

• In absolute terms, a project failure or disastrous investment can wipe out whole companies and individuals.  To mitigate against this, many will syndicate – or spread – risk across many people or many companies
• Moving parts issue: large initiatives have lots of “moving parts” – schedules/ people/ companies – if any one part falls off the track, then the whole thing is impacted.  To mitigate this, project managers will embed buffer time, redundant/ multiple suppliers, independent project reviews, frequent milestones, and program management oversight.

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