BASE jumping is one of the most dangerous sports a human can undertake, with one fatality per 60 participants. The desire to jump from great heights is practiced by a small percentage of extreme sports enthusiasts. BASE jumping, like sky-diving, skiing potentially fatal slopes, or rock climbing without a rope, is a high-risk activity.
According to The New Zealand Medical Journal, the likelihood of injury or death from BASE jumping is 5 to 8 times greater than skydiving. Why would any sane person take such risks? Dr. Erik Monastery, one of the authors of the study, noted that BASE jumpers score high on a measure called novelty seeking: the person’s propensity to become easily bored and look for exciting activities. They also have a low sense of harm avoidance, so they have the advantage of “confidence in the face of danger and uncertainty, leading to optimistic and energetic efforts with little or no distress.”
Some have characterized those who regularly take such risk as adrenaline junkies or daredevils. They actively seek sensation in activities like skydiving. Dr. Cynthia Thomson of the University of British Columbia suggests that risk-taking behavior may be genetically based. Her research found that people attracted to dangerous sports shared a common genotype, a variant of the DRD4 receptor commonly called the “adventure gene.”
So, is risk-seeking behavior genetic or a matter of choice? How can we use these answers to make better decisions and lead happier lives?
What Is Risk?
Uncertainty pervades every aspect of life; the future is unknown. The term “risk” refers the negative aspect of that uncertainty – the possibility that something harmful may or may not occur. Risk differs from loss just as uncertainty differs from certainty. Running across a busy street blindfolded is a risk; getting hit by a car while doing so is a loss.
Risk is present in everything we do. For example, a person could be injured by a herd of stampeding zebras while walking the streets of Manhattan, although there are no recorded instances of such occurring.
For that reason, the Stanford Encyclopedia of Philosophy refined the definition by replacing the word “possibility” with “probability.” In common terms, risk is referred to as “odds.” For example, the probability of your home being damaged by a fire in the coming year is about one-quarter of 1% (0.0028%) while the probability that you will die in the future (based on current science) is 100%. The risk of death is not an if, but when. However, probability alone is not enough to understand risk and effectively manage it.
A second dimension of risk is consequence. In other words, what is the impact upon those experiencing the event? The impact may be slight or catastrophic. For example, the probability of the paperboy tossing your morning edition into the shrubs sometime during the year is high, but the consequences are slight (inconvenience and possibly scratched retrieving the paper). On the other hand, the likelihood of a tornado destroying your home in Elmhurst, New York is low, but the financial costs of such an event would be significant.
Your Personal Risk Profile
Identifying your particular exposures to risk is the first step in risk management. Everyone is unique; each of us is exposed to different risks in varying degrees. A risk that affects one person may not be significant for another. An individual who lives in a rural area is more likely to be bitten by a coyote than hit by a bicyclist while a city dweller has a greater exposure to a careless bicycle messenger.
We also differ in our response to specific risks. One individual might forego health insurance, accepting the risk of high medical bills, while avoiding corporate stock investments. Another person may risk their health by participating in dangerous hobbies but employ an elaborate security system to deter thefts of property.
Your risk profile is the result of your capacity and tolerance to assume different types of risk:
- Capacity: The ability to absorb a loss or setback without affecting one’s lifestyle, physical health, or mental stability varies from person to person and from one type of risk to another. For example, professional golfer Phil Mickelson bet $20,000 on the Super Bowl winning team in 2000 and reportedly lost $2.75 million gambling in 2010. For most people, a loss of that magnitude would be physically and mentally devastating. In Mr. Mickelson’s case, it represented a small amount of his reputed $30 to $40 million annual income. Mr. Mickelson has a significant capacity to take financial risk. Before voluntarily assuming a risk, you should always ask:“Can I afford the loss if it occurs?”
- Tolerance: What is your attitude toward risk? How comfortable are you taking risks? Our willingness to assume a specific risk is directly correlated to our knowledge of the uncertainties associated with it. The more we know, the better we understand; the unknown becomes known. For the same reason, extreme sports athletes, soldiers, police officers, and firefighters undergo intensive training and hours of practice in different scenarios to identify, understand, and anticipate the risk they might face in real situations. When faced with a situation that might lead to loss, ask yourself: “Do I want to take this risk?”
A person who is required to assume more risk than they can afford or psychologically accept will experience anxiety and physical tension as a consequence.
For example, financial advisers regularly assume that a young client can take above-normal risks due to their long investment horizon. As a consequence, the advisers frequently suggest the purchase of high-growth, volatile securities to achieve maximum returns. However, clients with a low-risk tolerance are likely to find the subsequent portfolio volatility uncomfortable, even distressing. The better investment advisers always seek to understand their client’s risk profile before making suggestions.
Developing Your Personal Risk Profile
A personal risk profile consists of qualitative and quantitative analyses. The value of the profile will be directly correlated with the depth and quality of your analysis of your:
- Quantitative Assessment: The first step in developing your risk process is to understand your capacity to take risks. Identifying those risks to which one is exposed, followed by an estimate of their probability and impact, will enable you to categorize, prioritize, and manage each risk and limit your exposure. While most risks are universal (premature death, disease, accidents, violent weather, economic recessions, theft, etc.), the probability and impact of each vary from one individual to another. This variation is due to each person’s unique demographics, including age, sex, marital status, children, occupation, physical location, and lifestyle. Many begin the assessment by completing one of the different risk exposure questionnaires available on the internet. For example, the International Risk Management Institute offers a free questionnaire that includes a broad variety of possible exposures.
- Qualitative Appraisal: This step is designed to help you understand your tolerance for risk. Following the quantization of the probability and impact of a risk, how comfortable are you in assuming it? Professors John Grable (University of Georgia) and Ruth Lytton (Virginia Polytechnic Institute and State University) developed a risk tolerance scale in 1999 to assist financial advisers to better understand their clients’ willingness and comfort to take risk. A copy of their questionnaire and a key to self-scoring is available on Rutgers University’s website. A number of online tolerance questionnaires are also available from financial services firms, arising from the fiduciary requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
While an online questionnaire is a good starting point to understand your tolerance, it should not be considered conclusive. Alan Roth, the CEO of an hourly-based financial advisory firm, warns that risk tolerance is as variable as applying sunscreen; it depends on the weather. In other words, risk tolerance changes as one’s circumstances change.
Despite the failings of a risk profile, a rough understanding of your capacity and tolerance for risk is better than no understanding at all. Knowledge is critical to effective management of risk, whether making an investment or choosing to smoke.
Humans continuously manage everyday risk, often instinctively. Fear is an emotional trigger to avoid risk, though sometimes irrational or inappropriate. For example, the danger of being bitten by a dog is present whenever the animal is near, but the fear of the event is the result of experience. We consciously manage our fear and the risk of injury by avoiding strange dogs. Accordingly, some have defined risk management as “a discipline for living with the possibility that future events may cause adverse effects.”
Contrary to popular perception, most participants in high-risk activities are not fearless nor reckless gamblers. According to psychologist Eric Brymer, “They’re actually extremely well-prepared, careful, intelligent, and thoughtful athletes with high levels of self-awareness and a deep knowledge of the environment and of the activity.”
Warren Buffett, one of Wall Street’s most recognized icons, regularly invests millions of dollars in companies while others sell. According to him, “risk comes from not knowing what you are doing.” However, Buffett is surprisingly risk-averse, refusing to invest when he doesn’t have a full understanding of the situation. “Risk is a go/no-go signal for us – if it [investment] has risk, we just don’t go ahead.”
In other words, Buffett, extreme athletes, and others who regularly engage in risky activities have learned to follow the advice of University of Chicago economist Raghuram G. Rajan: “Not taking risks one doesn’t understand is often the best form of risk management.” In short, they manage the risks they voluntarily assume.
Categories of Risk
Avoiding all risk is impossible in the modern world. As a consequence, we need to prioritize our management of those perils that are most likely to occur and will cause the greatest damage. Professional risk managers analyze each dimension of a risk, then prioritize them by categories:
- Low impact, Low probability: This class consists of risks that rarely materialize, and if they occur, have little effect on our lives. For example, paper cuts infrequently happen and rarely require treatment.
- Low impact, High probability: Risks in this category are moderately important since they are likely to arise. Fortunately, if they happen, you can easily cope with them and move on. Mosquito bites are frequent and painful, so most people use repellent when the little blood-suckers are active.
- High impact, Low probability: While these risks can be devastating when they occur, they are rare. Nevertheless, since the scale of their impact is significant, managers take action to reduce their magnitude. Even though mosquito bites are common, becoming infected with West Nile fever is not. If one lives or travels in a region where the fever is present, prudent travelers take a preventive vaccine to avoid the worst symptoms of the disease.
- High impact, High probability: One example of this type of risk is living in a mobile home within the region of the U.S. called Tornado Alley. Management of this category of risk is imperative and of the highest priority. While you might survive a twister, you are likely to suffer broken bones and damaged property. Reducing the probability of being caught by a tornado by moving to a region less prone to violent weather would be the optimum strategy. If that is not possible, investing in an external “safe room” or ground shelter might save your life (lessening the impact).
Strategies to Manage Risk
Daniel Wagner, CEO of a Connecticut-based cross-border risk advisory firm, advised in his book Global Risk Agility and Decision Making, “Some risks that are thought to be unknown, are not unknown. With some foresight and critical thought, some risks that at first glance may seem unforeseen, can, in fact, be foreseen. Armed with the right set of tools, procedures, knowledge and insight, light can be shed on [the] variables that lead to risk, allowing us to manage them.”
There are four classic strategies to manage risk:
Eliminating your exposure to a particular risk is the best way to manage it. For example, Bill, deathly afraid of flying, lowered his risk of dying in a plane crash by never flying.
Unfortunately, in efforts to avoid one risk, we sometimes unknowingly substitute another in its place. To avoid the risk of an airplane crash, Bill turned to his automobile for long distance travel. According to the Insurance Journal, the odds of being killed in a plane crash are 1 in 96,566 while the odds of dying in an automobile crash are 1 in 112.
Not all risks are avoidable, especially uncontrollable events such as weather, political change, or economic disruption. When a risk cannot be avoided, other risk management strategies must be employed to mitigate the damage.
Risk can be reduced by lessening the chances of the risk occurring – reducing its probability – and diminishing its impact when it does happen. For example, the prospect of being injured or killed in an automobile crash can be lowered by practicing good driver skills and defensive driving techniques. If an accident occurs despite our vigilance, vehicle damage and passenger injuries can be reduced by wearing a seatbelt and driving automobiles with superior structural integrity.
Risk reduction is best employed when a risk can be identified but is unavoidable. For example, prudent investors cope with stock market volatility by limiting their use of margin and diversifying, i.e. spreading their investment across multiple industries and companies. Ideally, their portfolio contains investments that respond differently in the same economic environment, some stocks rising during bear markets while others fall and vice versa.
A traditional strategy to manage risk is to transfer it to a third party. While insurance is the most common method of transfer, other methods include the purchase of warranties, third-party guarantees, leasing rather than buying, and outsourcing responsibility to independent entities.
Insurance is available to cover all kinds of personal and business risk. Figures compiled by the Insurance Information Institute indicate that 2015 annual premiums collected by 5.926 insurance exceeded $1.2 trillion. The industry accounts for about 3.0% of the nation’s gross domestic product and employs more than 2.5 million people. Insurance companies spend more than $6 billion annually to attract customers, according to the Insurance Business magazine.
Harvard professors David Cutler and Richard Zeckhauser claim that a result of the widespread acceptance of insurance is its use when the purchase appears illogical. In other words, individuals are so risk-adverse that many illogically pay more in premiums than absorbing the actual cost of a loss. They cite the example of repair or replacement insurance for “inexpensive electronic products that seldom fail.” Nearly 80% of consumers opt for insurance even when the loss would have a negligible effect on their standard of living.
Some risks cannot be avoided, reduced, or transferred, such as losses that might occur due to an act of war. Other risks are extremely unlikely or too impracticable or expensive to manage. For example, damage to a house caused by the shock waves from an aircraft traveling at supersonic speeds is rare and excluded from most insurance policies. Employing building materials impervious to shock waves would be extremely expensive.
Some risks are accepted by choice. For example, companies engage in research and development activities despite the risk that the effort will be unsuccessful. The companies assume that risk because they expect the potential returns of a successful effort to justify assuming the risk of failure. Individuals often pursue advanced degrees in the hope that the costs of the education will be offset by increased earnings as a result.
If a risk is purposely assumed, the risk-taker should be prepared for dealing with the consequences if the adverse event occurs. For example, parents and adult children should be aware of the possibility of having to live together at some point in the future. According to a Pew Report, 20%-25% of young adults return to live in their parents home after being independent. A well-developed contingency plan will minimize the angst and obstacles that night otherwise accompany the move.
Personal Risk Management in Action
While the probability and impact of each risk vary from one individual to another, there are risks that affect everyone. The following four items identify several of those risks and illustrate strategies to manage them.
1. Premature Death
Mark Twain claimed that a man who lives fully is prepared to die at any time. That preparation includes fulfilling financial responsibilities to loved ones if death occurs unexpectedly. While death is a certainty and not a risk, a premature death often leaves financial goals – care and education of children, financial security for a spouse, payment of debts, and funeral expenses – unfulfilled. If you lack the assets to meet your financial obligations, the most common strategy is to transfer the risk to others.
Owning life insurance can offset the financial impact of dying before one’s time. Do you know how much life insurance you need? It depends on your financial condition, current and future obligations, and your ability to meet premium payments. If high premium payments limit your ability to buy an appropriate amount of coverage, consider the differences between term and permanent insurance.
2. Bad Health or Physical Trauma
As we age, the chances of being hospitalized increase. A 65-year-old man is almost six times more likely to be admitted to a hospital than a 30-year-old. Also, the cost of care can be devastating: fixing a broken leg can cost up to $7,500, and a three-day hospital stay is around $30,000.
A 2016 study in the JAMA Internal Medicine Journal found that the average out-of-pocket cost per hospital day for an insured patient ranged from $1,219 to $1,875, the difference attributed to the type of insurer. Depending on one’s sources, high medical bills are the cause of 18% to 56% of personal bankruptcies filed annually in the United States.
These costs don’t include lost wages while a person can’t work, whether temporarily or permanently. While the Social Security safety net provides some income – a monthly average of $1,171 in 2017 – it is barely sufficient to cover necessities.
Transferring the risk to an insurance company is usually the best option as the probability of hospitalization, disability, and lost income is quite high during a lifetime. For the members of a family, the odds are higher still. Even those in seemingly good health can have a medical emergency.
Medical and Hospital Bills
Having health insurance can defray expensive, unexpected medical and hospital bills. If you cannot transfer the risk due to the cost of premiums, there are options available to get medical care without health insurance.
According to Social Security figures, one of four 20-year-olds (male or female) will become disabled before they reach a normal retirement age. The Federal Government provides a public safety net for those with a disability, but it is barely above subsistence. Short- and long-term disability coverage is important if you are young.
3. Income Loss
Oxford researchers Carl Benedikt Frey and Michael Osborne found that almost one-half of workers in the United States have jobs that are likely to be replaced by automation in the future. The practice of replacing lost jobs with a series of temporary, freelance, on-demand work has been labeled the “gig economy.” A survey by the Freelancers Union estimated that 53 million Americans currently work as freelancers.
The causes of income loss are diverse, ranging from unemployment to bad investment results. For most people, lower income follows a decision to retire. Since the risk of lost income cannot be transferred to another by insurance, the best strategy is a combination of avoidance, reduction, and acceptance of the risk.
Avoid the Risk of Unemployment
Ensuring permanent employment requires a combination of defensive and offensive actions. Paul Bernard, a 20-year veteran of job coaching, recommends steps to avoid losing your job, including understanding the employer’s priorities and learning to play office politics.
On the football field, the best defense is a good offense. The same goes for career and income security. People who excel at their employment are simultaneously least likely to be laid off during a recession and most likely to be the recipient of higher income and status. As a former employer, as well as an employee who successfully climbed the corporate ladder, I employed various strategies for job promotions, raises, and bonuses. In short, star players are rarely cut in athletics or business.
Reduce the Impact of Unexpected Lost Income
Job loss, divorce, or retirement can drastically affect one’s income. Nevertheless, there are steps you can take to shoulder the blow.
Establishing a fund for emergencies will avoid compounding your financial difficulties. Rather than having to borrow money or sell assets prematurely, building a cash reserve during good times will help you make through hard times. It may actually be beneficial to have two emergency accounts – one for short-term, immediate exigencies and a second for long-term, large-scale crises.
Protecting a family from financial chaos after divorce is critical despite the emotional stress that accompanies a split. Stay-at-home mothers are especially vulnerable to the consequences of a broken marriage. Even couples who maintain civil relationships find it difficult to suddenly support two households on the same income that previously supported one. There are various ways to avoid financial hardship after divorce, including slashing spending until reaching financial stability.
Accept and Prepare for the Risk of Lower Income in Retirement
At some point in their lives, most people retire by choice or necessity. Unfortunately, few prepare for the significant drop in income and the effect upon their lifestyle. According to a Social Security report, about one-half of American households age 55 or older have no retirement savings. These households are entirely dependent upon monthly Social Security payments for income, averaging $1,341 in January 2016.
If a household does have savings, converting that sum to a lifetime monthly annuity will add about $649 in income during their retirement years for a total of about $2,000 monthly or $24,000 annually. According to recent Census Bureau records, the median household income for people immediately before retirement (Ages 55-60) is $62,802. In other words, even those with savings are likely to experience a 60% drop in income when retired.
Rather than experience the risk of a reduction of income in retirement, you can prepare for the contingency over your working years by building up your retirement fund. In an earlier article, I gave the example of a friend who opened an IRA in 1974. Over the next 39 years, he contributed the maximum amount allowed under the plan, a total of $180,000. Even though he was a conservative investor, his account was worth more than $502,000 when he retired in 2013. By anticipating his drop in income when retired, he was able to take the sting out of the bite.
4. Asset Loss
Physical assets can be destroyed, stolen, lost, broken, or become obsolete and worthless. Intangible assets, such as currency, securities, patents, proprietary information, or reputation, can also lose a portion or all of their value. The risk of loss in the things we value is ever present.
Fortunately, the risks of loss in many cases can be transferred to others by the purchase of:
- Home/Building Insurance. Mortgage lenders typically require borrowers to acquire homeowners insurance coverage to protect their liens on residential and commercial property. The coverage can include repair or replacement of the structure, the contents of the structure, and liability for any harm caused to third parties while on the property.
- Automobile Insurance. All but one of the fifty states (New Hampshire) require liability insurance coverage on autos. Lenders typically require comprehensive and collision insurance on any vehicle they finance. There is insurance to cover the difference between market and loan value if the latter exceeds the former in the event of a total loss and insurance designed specifically for classic and exotic cars. Many car owners buy extended warranties to avoid the risk of the high repair costs due to mechanical breakdowns.
- High-Value Physical Asset Insurance. While homeowner insurance might cover the replacement cost of some items, it is unlikely that jewelry, furs, art objects, or collectibles with values above $1,000–$2,000 are protected. Riders for an extra premium can be added to homeowner insurance. Policies from specialty insurers are also available to cover the risk of loss. When buying such insurance, remember to regularly check market values to be sure you are fully protected. British actor Rowan Atkinson crashed his £640,000 McLaren F1 in 2011 and received a payout of £900,000 for repairs under a special policy. Unfortunately, Rowan failed to raise the insurance amount to cover the increasing value of the car valued at £3.5 million at the time of the accident. In 2015, he sold the car for £8 million ($12.2 million).
The risk of loss can also be transferred by outsourcing tasks to others. For example, rather than bearing the risk of obsolescence, one can choose to rent versus purchase, or contract the responsibility to a third party. For example, many attempt to reduce the risk of poor investment performance by hiring professional advisers or purchasing mutual funds.
Whether risk is transferred or not, owners should take special precautions to reduce the probability of asset loss by:
- Taking Appropriate Security Measures. Steps like making a home burglary-resistant and protecting sensitive information from computer hackers lessen the possibility of theft by nefarious parties. Business owners need to be proactive to prevent fraud and employee theft. Intangible assets such as patents, trademarks, and other proprietary items can be protected legally while information loss by departing employees can be restricted by contract.
- Maintaining Assets in Good Condition. Regular maintenance of your home and automobile will protect the value of your possessions and avoid cascading problems of damage and neglect. In many cases, hiring a professional contractor is less expensive than DIY. Limiting stock market losses through the use of stop orders is a proactive way of keeping your investments in good shape.
- Hedging the Risk. Systematic or undiversifiable risk is inherent in all investment assets. It is unpredictable and impossible to avoid completely. Diversification of assets is one way of reducing market risk. Others include avoiding high volatility securities, leverage, and taking contra-positions. The latter refers to holding simultaneous positions in two investments that react in opposition to the same stimulus. For example, high-growth stocks do best in stable economies when investor enthusiasm is high while utility stocks do better in declining economies or recession. With the appearance of registered options, some investors use covered call options to reduce risk.
The best way to reduce risk in your life is to remain vigilant. Staying abreast of current events and the risks that affect you is the key to prevention and reduction of loss. Whether you believe in fate or super-forecasters, uncertainty about the future is ever present.
Each of us decides how we will deal with risk. Werner Herzog, the German filmmaker, is risk-adverse: “I prefer to be alive, so I’m cautious about taking risks.” Meanwhile, Sonny Mehta, Chairman of the Knopf Doubleday Publishing Group, is more aggressive, finding “something attractive about taking risks.”
Whatever your risk profile, exposure to some risk is inevitable. Learning to identify, quantify, and manage risk is essential to physical, psychological, and financial well-being. When faced with an unavoidable risk, remember the advice of Mark Zuckerberg, the founder of Facebook: “The biggest risk is not taking any risks.”
What do you think? Are you a risk-avoider or risk-taker? How has it worked out for you?