By Nathan Carmany
This weekend my family took a wonderful trip to a state park. We hiked, laughed and played games while enjoying our time with each other. Later, as we tried winding down, my two-year-old found her second wind and discovered the joys of jumping on the bed. Soon, the nursery rhyme Monkeys Jumping on the Bed filled the room. The more we sang, the more Nadia laughed and squirmed with delight. As you can imagine and ironically as the song states, she soon fell off and bumped her head. She escaped unharmed, but the parental instinct in me started weighing the risks of a horrible accident. The activity quickly ended. I was soon asking myself questions about how we address the issue of risk.
What is risk?
Risk, as defined by the web, includes : 1. A situation involving exposure to danger. 2. Expose (someone or something valued) to danger, harm, or loss. These are two descriptions of risk, but the meaning slightly differs when examining it from the finance lens. Investopedia defines it as ” The chance that an investment’s actual return will be different than expected.”
There are four alternatives one can take in addressing risk: avoidance, reduce, retain, and transfer. The best choice depends on a function of cost and the likelihood of the event taking place.
In ten seconds, name as many activities as you can which you avoid. The natural follow up question should be why do you avoid them?
You avoid them because of the high probability and high cost potentially associated with the event. For example, jumping out of an airplane without a parachute or bungee jumping is not attractive due to the highly catastrophic nature.
To reduce risk, choose a direction in lessening the negative result of the action. For example, people put on a seat belt in a car. Putting on the belt does not reduce the chance of a car wreck, but it does lower the cost of a negative result of not being thrown from the vehicle by keeping you restrained. This is desirable for high probability and low-cost events.
Did you refuse to pay for the insurance on your smartphone? If so, why?
People will retain the risks for events that are low cost and maintain a low chance of happening. In our example, losing a phone is not preferred; however, the cost of a few hundred dollars does not create a life altering risk.
States request that we deal with the high cost and low probability events with automobiles by having insurance. In a similar fashion, banks tell us to maintain a certain level of insurance coverage on homes if there is a mortgage.
The purpose for transferring the risk of low probability, high-cost events is to eliminate catastrophic dealings.
Below is a graphic illustrating the points we have discussed. While risk may be a complicated subject, this information allows you to see it from a different angle.
What challenge are you addressing? Review the potential cost and the likelihood of any outcome. If you feel the issue remains complicated, contact the appropriate professional to review a plan of action. If you do not know who to contact for a financial challenge, let me know, I will help you find the correct direction.