From the day we are born, we learn how to deal with the various risks surrounding us. With time, we learn from experience how to handle particularly risky situations. Still, managing risk is not an exact science or art. We have to struggle to avoid becoming victims of our own bad judgement.
Risk has been defined as ‘the potential of losing something of value’. Most value physical and emotional health, social status and financial well-being. The price we pay to achieve these values is based on common sense, hard work, and the cultivation of sound judgement about what is good for us.
Managing risk is a perpetual challenge, primarily due to uncertainty. Risks evolve, and past experiences are not enough to prepare us fully for what may lurk behind the corner to disrupt our lives. No matter how diligently we safeguard the things we hold dear, we are constantly confronted with the unknown. The outcomes of our risk management efforts are inherently unpredictable, making risk measurement a daunting task.
These quasi-philosophical reflections on risk should create the proper context for those who try to optimise the return on their lifetime investments in the present extraordinary economic context. With financial markets undeniably affected by political leaders and regulators’ fiscal and monetary decisions, it becomes increasingly difficult to judge the likely outcome of one’s investments when normality returns to how these markets operate.
The historically low interest rates that prevailed in financial markets for more than a decade distorted the pricing of risk, which is a very imprecise science even in normal times. For instance, some small investors who depend on the interest of dividends they get from their investments are often numb to the risk they take when they seek to optimise their returns by increasing their risk appetite. They usually do this when their threshold for tolerating the possible negative outcome of such a strategy is at its lowest.
The most prudent approach to valuing the risk of a particular investment is to consult with someone less emotionally invested in the decision-making process
Risk perception is a deeply personal judgement. Five individuals, each examining a specific investment strategy in a well-defined context, may arrive at five distinct conclusions about the severity or likelihood of the risk. Therefore, the most prudent approach to valuing the risk of a particular investment is to consult with someone less emotionally invested in the decision-making process. The potential ramifications of taking certain risks are significant.
Low-risk options often let us sleep at night, but over time, they could erode the value of whatever we want to preserve, whether this is our physical or financial health. High-risk options almost always initially excite us but may ultimately depress us. With the benefit of hindsight, we often reflect on how stupid we were when embracing high-risk options without bothering to calculate the price.
Greed is one of the main threats to managing and pricing risk judiciously. This applies to mundane activities, such as eating habits, and more complex processes, such as deciding what to do with money.
With political leaders and central bankers making decisions that distort the dynamics of free money markets, it is no wonder that investment advisers find it hard to guide their clients on how to price the risk of the possible opportunities to preserve and enhance the value of their savings. The fiscal and monetary tactics in the last decade have avoided an economic collapse in most countries.
However, the present uncertainty about the direction of interest rates and the increasing geopolitical risks make it difficult to predict how financial assets will likely perform in the next few years. Central banks have stopped printing money to ease the debt burden on distressed states. However, financial markets are still nervous due to increasing geopolitical uncertainty and economic stagnation, especially in the EU.
Analysts find it difficult to predict when financial markets will eliminate the current uncertainty. While the equity and debt markets show no sign of undue nervousness, the political risks sparked by the war in Ukraine will not disappear any time soon. A surge in sudden nervousness could lead to panic, and panic can badly damage the pockets of investors.
In times like these, prudence will always be a valuable asset. The often-repeated cliché that ‘there is no such thing as a free meal’ can easily be adapted to ‘there is no such thing as a risk-free investment’. Greed is always an investor’s worst enemy and get-rich-soon schemes often lead to big disappointments in life.
Pricing the risks we face in life will always be challenging.