9.1 What is Risk?
Learning Objectives
- Evaluate the interaction of probability and the severity of outcomes to determine the overall risk in various financial scenarios, such as coin flips and investment opportunities.
- Identify and categorize different sources of risk, including general economic conditions, company-specific factors, and financial risk factors, and explain their potential impacts on investment outcomes.
- Implement diversification strategies to minimize the impact of company-specific factors on investment portfolios, understanding the benefits and limitations of diversification in risk management.
Risk refers to the possibility of an unfavourable event occurring. The higher the risk, the greater the probability of an unfavourable event or the more unfavourable the event could be. The interaction of the probability of the unfavourable event and the degree of negativity associated with the event is critical to determining the risk.
Example 9.1.1
Imagine that you are going to participate in a coin flip. It will cost you [latex]\$1.00[/latex] to participate. If you flip a head, you get [latex]\$1.01[/latex]. If you flip a tail, you get [latex]\$0.99[/latex]. Even though there is a fairly high probability of the unfavourable event ([latex]50\%[/latex] chance of tails), the outcome is so minor (you lose [latex]\$0.01[/latex]) that this would be a low-risk event.
Now, consider a slightly different coin flip. This time, instead of flipping the coin once, you will flip it [latex]3[/latex] times. If you get [latex]3[/latex] heads, you receive [latex]\$10,000[/latex]. If you flip [latex]3[/latex] tails, you owe [latex]\$10,000[/latex]. Anything else you get your [latex]\$1.00[/latex] back. Even though the probability of the bad outcome is much smaller (there is only a [latex]12.5\%[/latex] chance of flipping [latex]3[/latex] straight tails), this is a much riskier event due to the bad outcome being substantially worse.
However, most people do not consider flying a commercial airliner a high-risk event (even though the worst-case scenario is quite severe) because of the extremely low probability of a fatal crash (less than 1 in 10 million). It is not just the probability or the degree of an unfavourable outcome but the combination of the two that matters for rational risk analysis.
In finance terms, our “unfavourable event” refers to earning less than expected. Any time we have a chance to earn less than expected on an investment opportunity, we are exposed to risk. Note that this is a more strict definition than defining risk as the possibility of losing money. We want to be careful to think of risk as the possibility of earning less than expected instead of losing money.
Sources of Risk
General Economic Conditions
- Inflation
- Recession
- Interest Rates
Company Specific Factors
Business Risk Factors
- Volatility of Sales
- Volatility of Input Prices
- Strikes and Other Labour Situations
- Product Lines
- Fixed vs. Variable Costs
Financial Risk Factors
- Degree of Debt Financing
Diversification
Diversification refers to the concept that by holding a number of different securities (ideally not just stocks) from a spectrum of industries, we can negate the impact of company-specific factors on our returns. We will come back to this issue (one of the most important financial concepts) in more detail later in this chapter.
Key Takeaways
Note that the above list is a sample of broad factors and not a specific list. For example, consider what happens when we have a significant increase in oil and gasoline prices. One immediate impact is inflation. The higher energy prices are, by definition, inflation in energy, but it goes beyond that. Now, it costs more for firms to distribute their products to suppliers, which is likely to cause inflation to spill over to other areas. As we search for alternative energy sources (like ethanol), we may see corn prices rising. Since corn is used to feed cattle, this could lead to an increase in beef costs as well. Also, if consumers are now spending more to fill up their gas tanks and more to buy a variety of food products, there would be less money available to spend on entertainment and other goods/services. This could lead to a recessionary environment (could, not will, because there are always so many influences on the economy that this is just one of many factors impacting economic growth). The point here is not the specific impacts of higher oil/gasoline prices but that many economic risk factors may have more complex interactions than are apparent at the surface.
One other thought on risk to remember as we move through this chapter. Throughout the chapter, we will treat risk and potential returns as primarily objective and measurable. However, in practice, one of the biggest challenges of risk management is trying to figure out what bad outcomes are and how likely they are. In practice, the results of our models are only as good as the inputs we put into them.
Attribution
“Chapter 7 – Risk Analysis” from Business Finance Essentials by Dr. Kevin Bracker; Dr. Fang Lin; and Jennifer Pursley is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License, except where otherwise noted.
