A Consultant's View

Prairie Trail Software, Inc. ............................................................. November 2008

How much risk can you stand?

The last few years of the oil and stock markets have been like a car full of teenagers after a party: high speed, fast corners, and then, a sudden sobering clash with reality. With that in our rear view mirror, it helps to look at how people handle risk. We, humans, react to perceived risk rather than actual risk, have different tolerances of risk in different areas of our lives, and we handle risk in different ways.

When a sixteen year old is handed the keys to the car for the first time, they have no concept of the risks they are taking. They certainly don't have any idea of what fears are running through their parents' minds. They simply want to drive. And in that difference, we see how people of different ages perceive risks. I've heard that people do not start to understand risks properly until they are in their thirties.

Part of the problem with identifying how people react to risks is that people handle risks in different parts of their lives differently. People can have different risk profiles in the physical realm from that of the financial, social, or ethical realm. So, a teenager may be so focused on avoiding social disapproval that they take drugs, shoplift, or drive recklessly - take financial, ethical, and physical risks. Other people may be so focused on avoiding financial risks that they take ethical risks.

Different people have different levels of risk that they are comfortable living with. This difference has deep implications for government regulations. We have mandated numerous safety improvements to automobiles and roadways. Yet, people still have accidents. What happens is that those who like to take greater risks drive more recklessly because their cars are safer.

The same thing happens in the financial world. Different people are comfortable with different levels of financial risk. We have seen attempts to use politics to change how much risk people have; communism removed many financial risks from the common people while putting major risks on the society as a whole. We see the financial regulators in this country try to manage risks and put in limits. Yet, nothing totally works. People who like risk will find ways around the rules and regulations to be able to take those risks.

One basic rule of risks in business is: just because someone else is able to make money doing something, that does not mean that anyone else will be able to make money doing that very same thing. People who understand the risks and know how to manage them will get out of the market before the risks kill them. Everyone else will be enjoying the returns until the risks happen and they are wiped out.