How Does Risk Affect Us?
Risk is everywhere. It affects everything we do and every decision we make. It can cause paralysis to our way of life, force us to become defensive and overreact, erode civil liberties, and destroy confidence. But risk is also necessary because it keeps us on our toes, forces us to check and double check our facts and positions, pushes us to innovate, leads us to seek information more hungrily, and adds the spice that makes life worthwhile.
Risk Aversion
Risk aversion typically refers to the behavior of a person who, when faced with two choices promising similar expected outcomes, will always go with the choice with the lowest risk. As an example, a risk averse investor faced with two investment choices yielding the same expected return will choose the investment choice with lowest risk.
It’s believed that the majority of people are naturally inclined to risk aversion, as opposed to risk loving behavior. While the risk averse shun risk, risk lovers are the opposite, and may select a riskier path than rationally necessary for the mere thrill.
Risk Tolerance
Risk tolerance refers to the amount of uncertainty a person is willing to accept in making a certain choice. It is widely believed that risk tolerance is highly dependent on a person’s age and wealth, among other factors.
Because risk is an integral part of life, and affects us constantly, the only certain way to avoid all risks is to not play the great game of life, which is to say, electing not to live. Needless to say, this is not an option.
Some risks affect us directly, and others indirectly. Direct refers to risks we’re aware of and plan for explicitly. Indirect risks are those that exist, but that we may not be aware of consciously. An example of the former is the knowledge that we should avoid being near a person who has a heavy cough. As soon as we identify the cough an alarm bell sounds in our heads telling us to beware of infectious disease risk. An example of the latter is the September 11th attack on New York’s World Trade Center. Until the moment it occured, this attack was in the realm of the unthinkable, and therefore prior to the act itself, such an outcome didn’t affect our decisions or actions. After the attack the entire world was forced to re-assess the notion of ‘unthinkable’ risk, and incorporate the new perception into all future risk assessments and decisions.
Risk Premium
More rigorous definitions exist but for our purposes it’s sufficient to define risk premium as the difference between the expected return of a risky venture and the risk-free or certain return of some other alternative which is acceptable to the participant. Risk premium may also be referred to as the ‘price of risk.’
In an economics setting the risk premium is the (minimal) additional amount of value or return that a participant demands in order to take the risky investment over the certain one. A highly risk averse individual would require a very large risk premium in order to make a risky investment.
Risk premiums may be affected by peoples’ preferences and concerns or fears. They may also be affected by supply and demand for certain investments, and by the general macroeconomic environment. Thus, risk premiums vary across investment types, among people, and over time.
When Risk Becomes Too Oppressive
When a risk is perceived to be too high by the vast majority of the population, it begins to hamper growth and prosperity. An important strength of societies is in the ability of risk-takers, whom we often refer to as entrepreneurs, to push the envelope. Some of these risk-takers fail, but those who succeed make an immense contribution to an entire society’s physical, economic, and spiritual well-being. For this reason, it’s important that the price of risk (risk premium) not be so high as to stifle progress. An historical example of such stifling or oppression may be found in the period of the Spanish inquisition, which significantly (albeit temporarily) reversed many freedoms introduced by the rennaisance. The threat of imprisonment, torture, and death smothered open-mindedness, entrepreneurship, and the seeking of knowledge.