3 Core Understanding of Risk to Improve Your Success Rate
In episode #85, we share 3 core understanding about risks. ‘Risk’ is often this big and highly emotional word that people throw around. And the word ‘risk’ can have a different meaning for each of us. So the question is, what are some objective ways to look at risk so that you can better manage your investments, allocate your resources and make better decisions in your life.
Tune in as we provide some frameworks to understand risk. What is risks? What kind of risks should you actually care about? How does your objectives as a retail investor affect your risks? What are some ways to go about handling negative risks?
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Hey guys, I know this month we’re supposed to talk about the future of work, but recently it has been a lot of discussion on our Telegram group about risk. And when I thought about that, I was like, “yeah, we don’t actually have a framework to understand risk”. A lot of us, when we think about risk right, it is very emotional, very qualitative, confirm got some extreme drama scenario and it builds a lot of emotions in us. In that sense, we don’t actually know how to look at risk from an objective manner. This results in an inability to manage our investments, allocate our resources and make decisions in our life. So, yeah, I have decided we will interject the theme for the month and today we’re going to spend some time to give you some core understanding about risks and basically provide a framework to understand risk. Welcome home.
Good morning everyone. I welcome you to another day with The Financial Coconut. In our podcast, we’re debunking financial myths, discovering best financial practices and discussing financial strategies that fits our unique life. You get it, ultimately empowering us to create a life we love while managing our finances well. And today we are going to spend some time to get a better understanding of risks, get some core basics and give you some frameworks so that in the future, it’s no longer this highly emotional, big ass word that people throw around. Risk, risk, risk, risk, risk, risk, risk… So welcome home.
When we talk about risks, what comes to your mind? Is it that, “oh my god, I’m going to lose my money and go bankrupt in a stock market”, or is it “housing prices are going to keep going up and I may never be able to get a house”, or “am I going to just work, work, work, work, work here forever and stay single?”
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I know everybody has a different idea, different concern and when we look at risk, right? Honestly, risk is one of those, like those… those words that is being thrown on on society, and everybody attaches a different meaning to it, but you use it so loosely that when you think about it, you don’t actually know what is risk. You don’t actually know what the person is talking about.
Words like love, responsibility… they all have similar traits because everybody attach a different meaning to it. They have a different experience that accentuates their underlying tonality for that word, but nobody can really sit down and help you understand what they’re saying.
There are no clear definition, there are no frameworks around this. So then what is going on? And to make things worse, I think these days are wah very jialat, okay. So you have all these people out there and also companies alike, they’re not shy of leveraging on our insecurities, our fears and our inability to understand risk, to sell us all sorts of stuff.
Of course the main culprit seems like is the insurance guys, right? Because risk insurance, risk insurance, they are kind of synonymous and yeah, it is fair because essentially, insurance is one of the risk management tools out there, but I’ve repeated myself again and again, the tool itself is not a problem. It is pretty amazing that in this century, we could outsource whatever things, whatever risks that we don’t want it to someone else, we pay them a price, they’re willing to take it up. But the problem is how much do we understand in this process, and are we paying a fair price for it? Are we overpaying, and are there other tools that are more effective and better? All those kinds of stuff. This is a rabbit hole, we will not go into this today. We can discuss this as we go along, which we have been doing all these kinds of stuff, which is great.
There are also other people that are leveraging on this, you know, like your investment guys. Property… big ticket items lah, essentially your automobile and whatnot. They will sell you based on a lot of high level concepts, right? “Oh yeah, this is a lower risk product.” “You know, this is like risk neutral and, you know, we are leveraging or the market”… blah, blah, blah, blah, blah, blah… all those kind of stuff, which honestly you don’t understand.
It’s like, I tell you all the feature of what is in an iPhone, right? You’ll be like “huh, can use 就好 (huh, can use good enough already)”. You don’t understand what’s going on, and I’m not saying that I can give you that pure understanding in two episodes, but I’m going to try to give you some frameworks so that the next time you have a better discussion with these guys. It’s not just like, “orh… Okay. I sign” like that, okay?
So in today’s episode, we’re going to focus on some core understanding of risk and give you some framework so that you at least can grapple this idea of risk in your head. I kind of know what is going on, even if you cannot actually calculate and de-risk yourself and all those kinds of things. At least you know what to ask and get a good understanding when you talk to all these people that are throwing this word ‘risk, risk, risk, risk, risk’ around. And next week’s episode, we’re going to focus on the three major risk factors that retail investors should be concerned about when they’re investing in a market. The reality is everyone is throwing the word ‘risk’ around and everybody means a different thing. And so what kind of risks should you actually care? Because as a retail investor, you have certain objectives and that would highly differentiate what kind of risks matters to you.
So to begin this discussion, I need to first define risks. What is risk? And I realized through my understanding and research is that there are multiple ways to do this. There are different models to look at risks and I’ve picked the one that I feel is the simplest to understand, and probably a great stuff for all of us, and that is the definition by ISO 31000 Risk Management Manual. How they define risk is risk is the “effect of uncertainty on objectives”. Essentially five words: effect of uncertainty on objectives. So there are two key words here, right? Uncertainty and objectives. If you think about it, what does that mean? It means that risks cannot exist in a vacuum. There must be a basis and you must frame it from the context of your objective.
To give you an example, okay, want to speak human… so let’s say tomorrow, I want to go cycle with some friends. Let’s say I want to go cycle with our favourite friends Xiao Ming, then the weather suddenly matters now. Hence the risk of rain becomes a thing. If I didn’t want to go and cycle, then weather conditions do not matter to me. There was no objective. The other thing that you should realize is that not all uncertainties matter, it is because I want to go cycle with my friends Xiao Ming that the risk of rain becomes a thing, right? The weather conditions become something I need to be concerned about, but whether or not our other friends Xiao Hua go shopping and go eat barbecue or whatnot, ain’t no shit is going to happen, does not concern. us.
So we need to recognize that we must have a clear objective when we are looking at risk and we must know what kind of uncertainties matter within this objective, because the reality is there are all sorts of uncertainties in this world and not all of them matter. There are probably only a handful of them that has a bigger impact on our objective. Hence, clarity on your objectives matter, and if we sidetrack a little bit into the personal finance space, this is also why I’m not supportive of people committing to insurances, investments or complex financial products until we have figured out some sort of idea of what is the life I want.
And that is not to say that you know, “I don’t understand compounding, I don’t understand… like life insurance gets more expensive if we start later. I don’t understand that property prices will keep going up as density in Singapore goes up”… I get it. We’ll be talking about it for a hundred episodes. But the idea here is that if your objectives are not clear, that means you don’t have some sort of clarity, at least for the medium term of your life, you don’t know what you’re going for, then everything is a risk and everything sounds very risky, okay? Borrowing a famous saying, “if you aim at nothing, you will hit everything”. By the way, while I was researching for this two episodes, I did watch a lot of video from Risk Doctor video on YouTube, so if you want to find out more, head over to YouTube to learn more from him.
With that, the first core understanding of risk I want you to understand is that not all risks are bad. Risks actually has direction, because if you think about it based on this framework, whereas risk is defined as effect of uncertainty on objectives, the effect essentially is a variation for what is expected, which means it can be positive or negative. If today, let’s say my goal is to get 50 marks and finally pass my Chinese exam. If I spend more time with a friend that is great at Mandarin (let’s say Xiao Hua), it increases my probability and my chances of doing better and I can potentially outperform my expected objective. If I spend more time with Xiao Ming, the guy that I cycle with and his Mandarin suck right, then it increases my risk factor of underperforming my objective.
To further distill the example, my objective is to pass my exam, pass my Chinese exam, get 50 marks. My risk factors are time spent with Xiao Ming and time spent with Xiao Hua in this example. Of course, there are other risk factors like whether do I study at home, whether do I go out to the arcade, and all those things are different factors that will affect the uncertainty on my objective. But just in this example, my two risk factors are time spent with Xiao Ming and time spent with Xiao Hua. In that sense, risk has direction and depending on what we do, it is not all good or bad. So if you put it in a more personal finance kind of example, right, there’s one risk that has been thrown around a lot, and it’s pretty fair. We’ll talk about this next week in more detail.
But just for today’s example: forex. Foreign exchange rate risk is something that is really talked about, and that is pretty good because if you think about it, forex is one of those classic examples where it can go up but it can go down. It can affect you positively or negatively, it is not all bad. To measure these risk factors, there are two broad ideas. Number one is frequency and probability: how uncertain is it? How are the chances of this thing happening and affecting our objectives? Number two is the potential impact, essentially the magnitude of this thing: when it happens, when scenario A happens, scenario B happens, scenario C happens, how is it going to affect our objectives?
So, positive risks can be seen as opportunity and negative risks are seen as a threat. And in that sense, every risk factor will have some sort of probability factor attached to it and some sort of potential impact factor attached to it. If we bring it back to the example of forex, foreign exchange rate risk, what a lot of people do in the finance space is they will hedge the downside. Beautiful, amazing, spiritual word of hedging…. We will talk about this in another episode. The idea is they will try to remove their negative risks, but nobody removes the positive risk. Actually foreign exchange rate risks can move in a direction that’s positive to you. So in that sense, the general idea is people want to remove their downside, eradicate that threat and amplify the upside, so amplified opportunity.
With that, I want you to be able to see risks in a more neutral light, that it’s not all bad. It can stage from the same thing like exchange rate movement, but it can be positive, it can be negative. Not everything is as clear cut as “oh this is good” or “that is bad”, and if we think about it, it’s highly dependent on your objectives. For a lot of portfolio managers out there, they are using the modern portfolio theory idea of creating consistent returns over an extended period of time, which we have talked about this in an early episode, I think episode 76, 77. You can check it out.
To them, volatility is a problem because too much volatility will not allow them to have consistent returns over an extended period of time, because that is the objective. But if that is not your objective, then volatility may not even be a risk anymore. Like Buffett said, volatility is rubbish. It’s not a way to manage risks or measure risk in a stock market because he is a value investor and he has a different way, different objective to go about investing in the markets, right? And of course some traders, they actually love volatility. “Wah more volatile, more movement, I can play around with my technical strategies and whatnot”.
Depending on your objectives and depending on how you look at the risk factors, they can benefit you in different, different ways. When people in the financial world use risk, they actually use it in a very neutral fashion, not in a very emotional storytelling way we retail people understand risk.
We bring it back to the same idea where risk is the effect of uncertainty on objectives, and depending on the different risk factors, a lot of them actually have directions and they move. They can move up, they can move down and affect your objectives in different fashion, so not all of them are bad.
Which brings me to point number two and that is: not all threats (which is negative risk) are avoidable, but you can probably transfer or reduce the risk factors and we will talk a little bit more about this after a word from our sponsor.
When people think about threats and negative risks, one of the first questions that they will have is “can this be avoided?” “Can we kill the risks?” “Can we remove this thing?” Huh huh, that’s the question. So I’m going to borrow an example to help me elaborate this idea. Let’s say you want to make 10% a year on your investment returns, or you want to do that 30 year, stay invested, long-term kind of idea and retire with some taitai vibes, right? Retire well, have a pretty decent retirement fund. I would say that you almost guarantee… you have to be in the stock market somehow to get the kind of returns, unless you have some sort of special skills. I’m throwing aside all the special skills, like you have a skill set that’s super in demand. You’re paid very, very well and you can compound that over time, or you have some sort of ability to flip properties or you know how to execute options, you know how to pick your stocks and you do a very high-performance… you do it very well, et cetera, et cetera.
If you don’t have some sort of amazing miracle, ability to produce very good returns, based on statistics, you will have to be in the stock market to get about 10% a year for 30 years. Essentially, the volatility risk of the stock market is unavoidable to you. You cannot avoid it if that is your goal, but you can reduce it. A lot of people recommend this, using the whole bond-stock, 60-40 balancing way to reduce the volatility of the stock market. I’m not saying you must do this. I’ve explained this in decent fashion in the early episodes of how to build your own portfolio, you can check it out. But the idea here is that based on your objective, some of these risk are avoidable. You have to take on this risk, but there are ways to go about managing and responding to this risk.
I’m going to share with you the 4 ways to go about responding to negative risks aka threats. Number one is of course risk avoidance, killing the threat altogether. That will mean that you totally don’t participate in it. So in that sense, you very much have to take a different way to go about achieving your objective or totally change your objective. In the case of, let’s say, I want to go cycle with Xiao Ming, and I’m afraid of the risk of raining, I’m afraid of the risk of the weather. Then I can don’t cycle, I change my objective. This risk no longer matter, or I can ask Xiao Ming to cycle with me indoor, like Peloton or something… wah you know go spin class and whatnot. The risk of rain don’t really matter anymore. You get the idea, we have to change… totally change the way to achieve the objective, or maybe even tweak the objective. It can be pretty extreme in the pursuit of risk avoidance.
The other way is risk transfer aka outsourcing your risk. In the personal finance space, it’s a very classic thing called insurance. Essentially, you’re outsourcing the financial risks of being critically ill or being disabled to some other parties. In the case of loss of income, they will replace your income. But I just want to clarify that no matter how much insurance you’re buying, it’s not going to reduce the risk of you being disabled or reduce the risk of you being critically ill. That does not change the stuff, okay?
Because your risk factors of being critically ill is why you eat, what you do, how you manage your stress. So if you want to reduce your risk of being critically ill, you got to change your diet, change the way of life, change your way of stress management, not buy more insurance. The insurance only cover the financial risk, a financial… possible financial impact if the critical illness comes onto you, knocks your door. I think that there’s some clarity that we need, so don’t, don’t keep buying insurance and say “aiya, can anyhow eat”. Okay [laughter] very weird but people do that.
The third way is risk reduction, essentially reducing the probability and reducing the potential impact of the risk factor. In the personal finance world, generally this idea of diversification is trying to reduce the risk of concentration, because you don’t want to have one or two tools only in your financial setup. If something happen to that tool, it’s going to affect your overall portfolio and it’s going to kill your objective. A lot of people promote diversification in the pursuit of reducing concentration risks. We’ll talk about that next week.
The last one is of course risk acceptance, just accept it lor. Because sometimes this risk, you cannot adjust no matter what you do, it’s very hard for you to mitigate it. So just be observant, recognize it, wait and see, and if something happens, you can revisit your risk management strategy. Which brings me to my third core understanding of risk and that is: a problem is not a risk, it causes risk. Sounds a bit like a wordplay, but let me clarify.
Because we define risk as the effect of uncertainties on objectives, we even go to the extent of attaching a probability factor and a potential impact factor on this risk. What we are seeing is these things have not happened and we’re trying to measure when it happens, how is it going to affect our objectives? That’s why they are called risk factors.
So foreign exchange rate risk is a risk factor. It has not happened. It can potentially move up, it can potentially move down, and how would that affect our objectives. You get the idea? But problems already happened, is here already. So essentially if we have to define problems, problems are effects of certainties on objectives. It is already here. How do we solve this? How does a problem then cause risk?
Let me give you an example. So there is a high level of employee dissatisfaction, everybody poking each other in the office, very unhappy with each other. What does this do? This is the problem, right? The problem is high level of dissatisfaction. One is the risk. It increases the risk of talent loss because a lot of people are unhappy. Maybe people will leave, right? So it increases the risk of talent loss. That is one thing, but let’s say a lot of people start quitting. Now talent already lost, they have left. So we have high level of talent loss, it’s already a problem. It happens. What does it increase the risk factor of? It increases the risk factor of a potential project delay. You get the idea?
Of course, this example is extremely simplified, but the major idea here is that a problem is something that has already happened, a risk is something that can potentially happen. Uncertainties versus certainties. And why is it important to see them differently? There is this thing called the risk problem cycle, which is what I’ve pointed out in the earlier example where a particular problem of high employee dissatisfaction increases the risk, increases the probability, increases the impact of talent loss, and now talent loss happened. So the risk factor became a problem. Now this problem of increased talent loss will then increase the risk factor of another thing, which is the potential project delay. So it becomes a risk problem, problem risk, risk problem, problem risk cycle… it never ends. Huh huh, so that is a very big problem.
In order to break this cycle, you have to manage risks because problem is not negotiable, it already happened. This is a problem, we need to solve it. But to break the cycle, we have to learn to reduce risk factors, which are uncertainties that matters, essentially they have not happened and we don’t want them to happen. We want to reduce the chances and reduce the impact if say, they happen. To borrow the earlier example of trying to make 10% a year on our capital for 30 years, 10% investment return year on year, what are some problems that we will face? Some problems, let’s say the bond market does not give that kind of yield, SG stock market is not growing like that, property market not growing like that. Let’s say property market grow at 10% year on year… wah, revolt huh. Interest rates are very low and whatnot, right?
So all these are the features of the reality. This is what’s happening. These are the problems, and if you can solve problems, you can achieve your objectives. So what is your solution? One of your potential solution may be to invest in the US stock market. Using this solution, you will be able to achieve your objective assuming history repeats itself. Not recommending you to invest in the US, using it as an example to elaborate the case.
So 10% year on year, local market’s not giving you the kind of returns. This is your problem. Your solution: go and invest in the US but what are the risk factors when you invest in the US? A few will be foreign exchange rate risks because the US exchange rate is volatile. It will move because it’s not your home currency, you live in Singapore. The other is higher volatility than the Singapore markets. Do you… can you embrace higher volatility within your portfolio?
So then how do you go about doing it? You manage the risks with different, different strategies, and all these we’ll talk about it in the next episode. But the idea is you need to be able to see the difference between a problem and a risk. Manage risk, solve problems. It is very different and in a sense, problems are not negotiable because they’re already here, they already exists. You have to solve it to meet your objectives, but in the pursuit of meeting your objectives, there are all these other risk factors that you can manage. So I want you to be able to see them in different light, and if you are able to see them separately, you have a lot more clarity as to what to do with some of these things. Because like I said, problems already happened, so solve the problem. Risks is uncertainties, potentially will happen. Reduce the risks, solve the problem, respond to the risks, okay?
With that, I’m going to sum up the three core understanding of risks that I believe you should have. Number one is: not all risks are bad. Risks actually has direction because we define risk as effect of uncertainty on objectives that actually has a lot of factors that can move two ways. One of it is forex, foreign exchange rate risks. It can move up and it can move down so it can be positive or it can be negative. So it is not all bad.
Number two is: not all threats are avoidable, but you can transfer, reduce, or maybe just accept it. Because some things, you just can’t do anything about it but at least be aware. Once you’re aware, you can create contingency plans and see how things work and review from there.
Number three is that: a problem is not a risk, it causes risk. For lack of a better way to put it, problem is not negotiable. You cannot negotiate the problem, you have to solve it, but in the process of solving, depending on what solutions you use to try to achieve that objective, there are all these risk factors that you have to work with. So solve the problem, respond to the risks by trying to reduce the impact, reduce the probability. So, yeah. I hope that gives you a much better understanding. I hope you learnt something useful today. See ya.
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Woohoo! Okay, that was a pretty fun episode. It gave me a lot more clarity about risks also in the pursuit of trying to explain it, so that’s great. And later this week, we’re also interjecting with the Chills to talk about NFTs. Because I think NFTs is something that a lot of people want to hear about. So far I think I found a great guy, some guy that I met on a fellowship with On Deck to come on… Reuben to talk about NFTs. So he will give us a much clearer explanation about what is going on. In that sense, if you love him, stay tuned because we are planning to run a crypto podcast on the site. Let’s see where this bring us. For next week, I will spend some time to share with you three risk factors that I think retail investors should look out for and how to manage it, or some of the best practices that people use to manage these risk factors.
So, yeah. I think we are growing very well, so keep supporting us. I will see you around. Take care. Bye!
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