Some Fundamentals
People differ in their views concerning risk and uncertainty. “Risk” generally implies the potential for loss (gain), an unfavorable (favorable) outcome, or danger (safety). A number of investors would think of risk in a semivariance or asymmetric sense: It’s only risk “if it comes out bad.” More generally, one thinks of risk as an outcome that may vary (favorably or unfavorably) as a result of the underlying process(es) that will generate the outcome. With respect to investments, many define risk as the chance of variability in the outcome.
Some characterize “uncertainty” as the doubt concerning the outcome. Uncertainty may stem from lack of knowledge about a potential outcome, or from variability in the outcome that has nothing to do with available knowledge.
An “outcome” that occurs at a point in time may result from chance, the influence of variables (for example a force), or a combination of both. Often the risk of a venture may have its origin in one or more factors. In a dynamic rather than a purely mechanistic environment, the inherent risk of an investment may vary with time. Alterations in the origins of risk result from changes in the array or level of influence of variables that affect outcomes.
One can sometimes limit risk by influencing or even eliminating the influence of certain variables on outcomes. Generally, these efforts have costs that will affect the net outcome of circumstance.
For ease of discussion, we will combine risk and uncertainty in a practical way: With risk and uncertainty, we don’t know for sure what will happen. Additionally, we will define “risk resolution” as the emergence of reality, the resultant impact on the variables that influence the outcome, and the event and the consequences that occur.
Core principle: We do not live probabilities or expected values, or predicted or modeled outcomes. We live the events of reality that arrive with time.
The demise of Long Term Capital Management (LTCM) in 1998, creating global financial panic, tells us that even the legends of Wall Street and the incredible talents of Nobel laureates cannot alter this principle. Shirreff (2004) illuminates a host of issues related to LTCM and other aspects of risk. The subprime debacle, as well as certain derivatives, shows that some continue to ignore fundamental principles, or harvest returns while foisting the risk and consequences of poor decisions on others. These and other historical events prompt us to share perspectives and common sense rules on risk.
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