I spend substantial time with insurance companies and so I have mastered the fine art of Risk Mitigation. Risk can be defined in many ways, but within the context of the financial community; Risk is defined at the potential for loss of dollars, and the degree of risk is to be defined as to what extent.
I am risk adverse. I avoid risk at every corner and turn. I do not like having myself exposed to a potential for loss, especially massive loss. I learned this lesson early in life when a college professor bought naked put options on oil, but in 2008; oil spiked drastically. For those unfamiliar with options; there are two types: Naked and Covered. Naked options essentially open you to the potential for UNLIMITED loss or gain. The potential for unlimited gain is nice, but I am not the biggest fan of the potential for unlimited loss. He lost his shirt back then; and it was in that moment I learned that you always need to have an understanding of your potential total risk.
You may hear the phrase, “No Risk, No Reward,” and in some sense this is true. But not all risk is created equal. Investments and life are not a roulette table where you put down $5 and you either lose it or gain an additional $5. If I buy a stock for $100; my total risk is $100, but this has theoretical unlimited upside potential; with defined downside potential. If you buy a piece of real estate for $100,000; your total risk is $100,000. Well, that’s not entirely true; you would leverage 75% of it; so your total risk would be $25,000. This is why some people (Think: Trump) can declare bankruptcy over and over again. He buys a parcel of land without putting up much of his own capital; the deal falls through and he declares bankruptcy; so he, in effect, does not lose very much and the lending institution is stuck with the fallout.
In order to prosper; you need asymetrical risk. This is where the upside is far greater than the downside; and the potential for a downside is small. I refer to this method as protecting your downside. If you protect your downside; the upside will follow through. If you were to buy a reasonably well respected company, such as Johnson & Johnson at a reasonable valuation; then your downside is defined and limited and, most importantly, not likely to occur., but the upside and cash flow are nearly limitless. If you were to buy Nautilus Minerals (
OTCMKTS: NUSMF – Currently at 0.039 as of this writing) then your odds are probably not much different than the roulette table. If you put $5 into this stock, you may come out with $5 in two years, maybe $10, maybe nothing, who knows? If I buy Johnson & Johnson for $100; I am fairly certain that in two years; I will still have that $100 plus a quarterly dividend payment; and there is a high potential it will be worth more than $100 in two years.
Get a basic understanding of various asset classes and the various risk elements associated with them. understanding this will give you a major boost in your quest for financial independence.
Now I am going to discuss my favorite type of risk metric; Opportunity Risk. Let’s assume you are someone who is 100% risk averse and want nothing to do with any type of risk so you keep all of your money in an FDIC insured bank account. If you do this; you are likely operating with a guaranteed loss relative to inflation. Example: You put $100 into a bank account on January 02, 2019 and receive a 0.40% interest rate so that on 12/31/19 you have $100.40. What is your loss? Your loss is $1.50. Inflation for 2018 ran 1.9%; so if we assume this holds true through 2019; then the goods and services you wish to buy will cost 1.9% more by the end of the year and you only made 0.40%. This is called opportunity risk because you are favoring a low performing asset over a high performing asset due to the fear of loss. The great irony in this is that even though you see the same dollar amount and does not change daily; you are losing the fight against inflation.
Do you understand risk and risk potential now? If you do not; then let me know!