David French | 18/02/2009 3:45:11 PM

This article was originally published as ‘Risk is not just a four-letter word’ in The Morning Bulletin on 7th December 2001.

Risk is a four-letter word and many people think it’s dirty. That alone makes it a worthwhile topic. Unlike most four-letter words however, the meaning of risk is often misunderstood.

People in insurance talk of risk based products. Underlying this is a philosophy that risk is bad. Insurance companies therefore think of risk in absolute terms and sell the idea of eliminating risk. They also seek to eliminate risk for themselves. The upshot of this is that you will be encouraged to buy the maximum amount of insurance. This is because of the inherent conservatism of the industry where insurance is priced on the basis that you are relatively likely to claim. In other words, where the insurer has identified a risk that may apply to you, the premium will be priced as if that risk does apply to you. For instance, at the time of writing, income protection insurance for all nurses is the same price, whether you risk back injury from heavy bed duties, or you are dressing wounds in an outpatients clinic. From an individual’s point of view, eliminating risk is expensive. To eliminate every risk in your life could cost all your money, which is obviously not practical.

Financial markets consider risk in less black and white terms. Underlying this is the assumption that we do not like risk, so if we expose ourselves to risk then we need to be rewarded. This is sometimes misrepresented as meaning that if you take on lots of risk, you will automatically be rewarded - it’s not as simple as that.

Scientists, engineers and statisticians speak of type 1 errors and type 2 errors. A type one error results from accepting something as correct when in fact it was wrong. Most everyday mistakes are Type 1 errors and they result from not being cautious enough. A type 2 error results from rejecting something that was accurate. Type 2 errors result from being too conservative and amount to throwing the baby out with the bath water.

This jargon can be applied to every day life and helps in assessing what you are told by your financial planner or stockbroker. If you put all of your money in a high-risk investment, there is a high probability that you will not get it all back and there is a small probability that you will make a killing. Put all of your money in a term deposit and there is a high probability that you will get it all back, but almost no probability that you will make a lot of money. The best strategies use a combination of investments reflecting your risk profile. You need to know something about yourself, and consider what risk you are prepared to accept. Saying you want no risk will be expensive in that you may be foregoing investments that are perfectly reasonable which have a greater return. Saying you like lots of risk might make you a lot of money but is more likely to lose money.

Some people become paralysed by trying to eliminate every risk – it is impossible to eliminate all risk and trying to results in missed opportunities. Other people like the idea of capital guaranteed investments – these appear to have no risk. Always remember that the guarantee is only as good as the company offering it.

The Investment Collective (AFSL 471728) is a non-aligned financial planning and investment firm specialising in providing tailored financial and investment advice for individuals and small business. Capricorn Investment Partners Limited's services include financial planning, share trading, portfolio management, insurance broking and self managed super fund administration. Additional information on services provided by The Investment Collective Limited can be found by following this link. Readers are reminded that this document has been prepared for general information purposes only, and any advice contained herein has been prepared without taking into account your financial objectives, situation or needs. Readers are advised to see their financial advisor prior to acting on any general advice.

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