What is risk?

Disclaimer: Please note that all content and information in this blog are for educational and informational purposes only and should not be taken as professional investment advice.

──────────────────

What is risk? 

Risk is often defined as the probability of loss.

Everyone has a different view and definition of risk. Personally, I view risk as our expected loss.

Expected loss is made up of two components: 

1. Probability

2. Impact

Probability x Impact = Expected Loss

And depending on how you quantify risk, I believe expected loss is a crucial aspect of risk, and can be a quantification of risk.

You may wonder: If our expected return on an investment is a loss, why invest in it?

To be specific, expected loss does not refer to the overall return of an investment as a whole, but rather a specific event. In other words: "If X happens, what is my expected loss?". 

Our expected loss is based on the occurence of a singular event, rather than a combination of events as a whole. For example, if the US Government defaults, what is our expected loss? We compute our expected loss based on specific events which we foresee might happen.

And if we compute our expected return/loss for ALL possible events, we would get our overall expected return/loss. But of course, it is impossible to compute for every possible event, so we narrow down either by the probability or impact of that event happening.

In short, we plan for what has the:

1. Highest Probability 

2. Highest Impact

And we can estimate our expected return/loss accordingly for these two events. Together, they make up one aspect of risk.

Is risk quantifiable?

Some believe risk cannot be quantified. This is true to some extent but I believe the fact that risk seems unquantifiable should encourage us to find a way to quantify it with reasonable precision and accuracy. Although risk seems unquantifiable, this doesn't mean we shouldn't try to find ways to quantity it.

However, we should remain cautious because quantifying risk may provide a false sense of security. Having confidence in our ability to precisely and accurately quantify risk may lead us to believe that we can safely predict the future.

Being able to quantity risk accurately does not mean you can predict the future. It simply means you know the risk of your investment, where the risk can be broken down into volatility or expected loss for example. You won't know how your portfolio will perform but you know how it will react to market conditions and what happens if the worst outcome materialises.

Conventional finance measures risk by volatility or sigma. This is not wrong but I believe volatility alone cannot define nor measure risk. 

In fact, risk is one of the most difficult things to quantify because there are countless ways to define and measure it. It is multi-faceted, and like a diamond, it has many sides and looks different whichever way you turn. In other words, risk is multi-dimensional. And volatility is just one aspect.

The other aspect I believe is as important as volatility is expected loss as mentioned.

Without expected loss, we won't know whether our investment is loss making or profitable if certain events should occur. Expected loss allows us to quantify our returns and as such our risk for specific events, since risk are commensurated with returns.

Negative Risk? (Theoretically)

Since higher risk demands higher returns, by right, negative risk should demand negative returns (losses). What exactly is negative risk? Certainty.

Personally, I believe the opposite of risk is certainty. With risk comes uncertainty, so with negative risk, comes certainty, where negative risk = absence of risk.

As risk entails uncertainty, the opposite of risk entails certainty. Based on this, to have certainty, you must accept negative returns. This is in theory but holds true to some extent in reality.

What gives certainty? The risk-free rate. Compared to the market returns, the risk-free rate technically gives negative returns. For example, instead of 10% returns (e.g. market return), you are getting 3% returns at the risk-free rate. 

So while you don't lose money per se, you are losing 7% of potential profits by investing in the risk-free rate instead of the market. In other words, -7% is the opportunity cost (or expected loss) for forgoing the market return in exchange for certainty. By accepting the risk-free rate of 3%, you lose 7% of potential returns.

In short, the absence of risk comes at a cost.

We can spend countless hours defining risk and discussing whether it is quantifiable, and how to quantify it if we can, but the key is this: it doesn't matter if you can quantify or explain risk. What matters is what risk means to you. Because what risk means to you determines how you will handle it.

Some people don't believe in risk and so do nothing to mitigate it. Some people believe risk can be quantified and as such derive complex models to optimise their portfolios to minimise risk and maximise returns. Some people don't believe risk can be quantified and as such take a qualitative approach to their portfolio's risk management.

Whichever view you have or whichever approach you take, what truly matters is that you are comfortable doing what you're doing. In other words, you're comfortable with the level of risk you're taking and how you're managing it. Risk is very much like stress. It cannot be reasoned away or removed but it can be managed. And if managed well, it will lead to a good outcome. 

How you manage risk also influences the risk of your portfolio. The better you manage risk, the less risky your portfolio is. Yet at the same time, managing risk too well can lead to overconfidence and overreliance on your definition and quantification of risk, leading to a false sense of safety, security and certainty which makes things riskier. So in a ways, risk is paradoxical.

Conclusion

In short, there's no right or wrong way to define or quantify risk. Risk is what you make of it, or as some might say, risk is the fear of the unknown — the fear of what we cannot predict.

──────────────────

Disclaimer:

The content and information provided on this blog is solely for educational and informational purposes, and should not be construed as financial advice. The accuracy or completeness of the content and information provided in the blog cannot be guaranteed. Before making any investment decisions, it is important for readers to research and carry out independent verification of the information provided, or consult with a qualified financial professional. No warranty and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of actions taken based on the ideas or information found in this blog.

No copyright infringement intended. The images used in this blog are solely for educational and informative purposes, and are © copyrighted by their respective owners.

Copyright © 2025. All rights reserved. SN Finance Blog