Understanding calculated risk and its impact on investments

Very often, one comes across certain clichéd terms, one wonders whether the user understood the meaning of what was said. The other day, I was having a discussion with someone who was concerned about the loss in an equity mutual fund account. He had been investing in this account through SIP for almost three years now. The moment I indicated that equity investments are always subject to a higher risk that this gentleman uttered a very commonly used phrase that he understood the risk and he always took “calculated risk”.

 

What is the meaning of “calculated risk”? What is the “calculation” in the “calculated risk” and what is the risk? These are very simple questions but have serious implications on one’s wealth and psychological health.

 

dictionary.com defines “calculated risk” as:

 

A chance taken after careful estimation of the probable outcome, as in taking their dispute to arbitration was definitely a calculated risk. This term uses calculated in the sense of "planned with forethought," a usage from the mid-1800s. Its pairing with risk dates from World War II, when the chances for losing bombers were taken into account before a bombing mission was sent out. After the war the term was transferred to other undertakings where taking a chance to succeed had to be weighed against the costs of failure.

 

“Risk” is taking a chance and “calculated risk” is taking a chance after considering the probable outcomes. One must factor in the implication of the outcome as well as the probability of such outcomes.

 

So often, the judgment of the outcome and the probability is colored by the present state of affairs. In bullish trends, the probability gets skewed towards positive outcomes, whereas one thinks of the negative too much when the going is tough. When the indicators are upward moving and the sentiment is positive, every piece of information looks positive and indicates better future. Exactly opposite happens when the sentiment is negative.

 

The sentiment often get driven by the prices in the market and thus, it becomes a self-fulfilling loop. The positive leads to even more positive and vice versa.

 

This is where one wonders if someone really knew the probability or the impact of the outcome. Risk involves making choices, and our emotions may have a role to play in how we make choices. The “calculation” in the “calculated risk” is supposed to mitigate the risks our emotions play.

 

There is another perspective to our approach towards risk. As Jason Zweig put it in one of his articles:

 

“We underestimate the likelihood and severity of common risks and overestimate the likelihood and severity of rare risks

 

When we feel we are in charge and we understand the consequences, the risks will seem lower than they truly are. When a risk feels out of hands and less comprehensible, it will feel more dangerous than it actually is.”

 

This means two things:
1. We are more likely to take higher risks in our own field of expertise
2. We can improve our willingness to take risk through increased understanding

 

This point no.2 has the potential to become dangerous if not understood properly. The operative word in point no. 2 is “understanding”. Mere knowledge of something is not enough – information will not suffice – data does not mean much. It is the understanding that is required. Very often, incorrect interpretation of the information may lead to someone taking undue risks or avoiding risks unduly.

 

The improvement in willingness to risk must be balanced with proper analysis of the need to take risk as well as one’s financial ability to take risks. Some of the risks may present higher potential rewards, but one must have the ability to go through the risky periods.

 

A proper assessment of one’s need to take risks, ability to take risks and the willingness must be balanced – and that is “calculated risk”.

 

Risk is not bad. Risk is just a choice. Any decision that one takes may have more than one outcomes, some of which undesirable. However, for the fear of such undesirable outcomes, we cannot stop making choices – as not making a choice is also a choice to go with the default option that someone else might have decided for us.

 

Take risks, make choices, enjoy life.