Question

In The Flaw of Averages, Sam Savage makes the claim that uncertainty is the nature of the Universe, but risk is in the "eye of the beholder." He uses the example of uncertainty as the chance that a particular stock will rise or fall on the next day and states that he is risk-free from falling stock price if he has sold the stock short. The only risk he experiences is if the stock goes up.

Do you agree or disagree with this definition of risk? Why or why not? Please justify and provide an example of another situation that backs up your perspective.

Answer 1

Risk in Financial terms involves pricing in the chance of something going wrong. Sam savage is completely right in assuming that he is risk-free from falling stock price if he has sold the stock short. The only risk he experiences is if the stock goes up as it will cost him the opportunity lost if he had held stock longer.

There’s very little chance of say a flood (if you live at the top of a mountain, then your flood insurance premium shouldn’t be high) whereas if you live in downtown New Orleans, it’ll be higher.

Aside from Acts of God, there’s another type of risk to price in, Fraud. Effectively, where people make off with other people’s money using business models that investors assume are safe as houses (i.e.bona fide investments). The hallmarks of which are to:

1. appear as if acts outside of the control of the people entrusted, got the better of them, and
2. obfuscate the transactions (making them hard to analyze).

Typical past example will be:

Worldcom Fraud reported in the summer of 2002 where the investor lost all of their investment because of companies fraudulent accounting practices. The lack of perfect knowledge among investor of the ongoing fraud was the risk which resulted in wiping off of their savings.

The chances of such risk can then be priced into a deal.