CC Biz Buzz: Assessing risk in finance
A nurse practitioner friend of mine enlightened me a few years ago about the idea of risk. She originally worked in cardiology and later transferred to the trauma bay and then to neurology. She knows her stuff after having to be an expert on not just general systems, but specialties like the body’s pump, the brain and the nervous system. I had always thought the risk of major physical trauma like gunshot wounds and car wrecks as being caused by fate or the hand of God, but I’ll leave the debate of causality to philosophers and theologians. I will, however, assume the idea of free will and the correlation to choices made in life.
Here, her insight was unexpected and revealing. Our choices lead to specific results, even to outcomes we believe are not under our control. We may not be able to prove causality, but we can accept the idea of correlation of choices made with specific outcomes, ones that could have been avoided if we had only avoided certain choices or behaviors. It was the behavior patterns, she said, which could predict much of the outcome that leads to trauma.
Risk can be expressed in a number of ways. With medicine, it may take the form of behaviors that lead to negative outcomes. Those decision processes need not have immediate recourse but may be chronic (for example, smoking and its effects on the body over the long term; the way it increases the likelihood of cancer or other ailments). It’s well-researched that we as a species are risk-averse, meaning we don’t necessarily like risk. Because of that, we need to be compensated for bearing it.
We assess risk in finance as well. One way is to look at the returns of an asset. Those returns, of course, could be negative or positive. Our desire is nearly always for the latter (unless we’re looking to the complexities of tax-loss harvesting). We hope that our deferment of immediate enjoyment will reap a profit down the road which will have an even greater utility. This is the heart of investing and it involves decisions to be made now which affect us down the road. With most assets we can think in terms of return. The flip side, though, is this idea of risk. Every action must have its consequence. Return cannot be discussed without risk. With well-established markets like a stock market, we can think of this risk as being the volatility of the asset price. How much does the price fluctuate? A stock like Tesla will be much more variable or volatile than the stock of Coca-Cola. By understanding the volatility, we can develop an idea about correlation. How are one’s assets returns related to another? This information can be quantified and information helps us put assets together in a portfolio — hopefully, a well-diversified one. One where our assets move independently of each other, as they are chosen not just because they are expected to provide a decent return, but because their correlation to each other is low, not correlated or even negatively correlated. By putting these assets together, we can be somewhat assured that our portfolio’s return, though perhaps not as great, is less risky.
Here at Columbia College, we’ve returned from Thanksgiving break. I wished my students all a safe holiday prior to taking leave. With it I hoped they would all make decisions allowing for a safe return to campus. Hopefully, all of us acted similarly and now prepare for a stressful but potentially joyful time. I know my students will be under extra stress as they prepare for finals and complete semester end projects and papers. What decisions will they make over the next few weeks so that they manage their course load with an end goal of a successful semester? Many of us face similar stressors this month. Will we manage our time and assets accordingly? Will my students continue a routine of eating healthy and hitting the gym? Or will they succumb to the pressures placed on them and deviate. Are we performing an inventory of our own behaviors that will aid us in our goals or will our actions hinder us? This applies to financial goals and personal ones where the concept of correlation may be more intuitive.
This is a good time to conduct such an inventory. Can our personal habits, practices and behaviors show correlation to successful returns or achievement of our goals? Take a bit of time to digest and think about such things, especially now at the beginning of this hectic month.
James Dugdale is a visiting instructor of real estate management in the Robert W. Plaster School of Business at Columbia College. He is a licensed real estate broker in the state of Missouri.
This article originally appeared on Columbia Daily Tribune: CC Biz Buzz: Assessing risk in finance
