Risk pervades our daily life. Without taking risk we cannot thrive. Every major advance
in human civilization has been made possible because someone was willing to take risk
and challenge the status quo. In man’s early days, physical and economic risk went
hand in hand. The development of shipping trades facilitated the separation of
economic and physical risk. Then came the Renaissance and scientific thinking. Various
advances were made in probability theory. Harry Markowitz’s portfolio theory was
another important landmark. Risk management has become increasingly sophisticated
in recent years thanks to the availability of a range of financial instruments. But as the
recent sub prime crisis shows, risk manangement continues to pose challenges.
What is risk?
Risk must have two attributes: uncertainty about outcome, impact on utility. A threat is
a low probability event with large negative consequences where analysts may be unable
to access the probability. A risk is a higher probability event where there is enough
information to assess both the probability and the consequences. Risk in finance is
defined as the variability of actual returns on investment around an expected return.
The Chinese symbol for risk is a combination of danger and opportunity, representing
the downside and upside of risk. The essence of good management is making the right
choices when it comes to dealing with different risks. The most successful companies
are good at finding particular risks that they are better at exploiting than their
The Duality of risk
It is part of human nature to be attracted to risk. At the same time, there is evidence
that human beings try to avoid risk in both physical and financial pursuits. Some
individuals take more risk than others. Utility from an additional unit of income will
decrease with wealth. Utility increases as wealth increases, at a declining rate.
Risk taking is affected by the way choices are framed. Individuals may be risk seeking in
some situations and risk averse in others. Individuals feel more pain from losses than
from equivalent gains.
Individuals are generally risk averse and more so when the stakes are large than when
they are small. There are big differences in risk aversion across the population and
noticeable differences across sub groups. Individuals are far more affected by losses
than by equivalent gains. The choices that people make when presented with risky
choices or gambles depend on how the choice is presented. Individuals tend to be much…
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