Enemy Of Your Money #5 - Risk

Paul K. Dunn
Jun 16, 2017
6 min read

Risk - The Financial Roller Coaster

Risk is like a rollercoaster ride. When something involves risk it is extremely important that you understand how to minimize it to its lowest form. Risk by definition is a situation involving exposure to danger. You can expose (someone or something valued) to danger, harm, or loss. Financially speaking, when your money is at risk, that is the something of value we are speaking of directly. However indirectly we are talking about your quality of life. When you leave yourself exposed to risk financially, you set yourself up for a catastrophe that may not be recoverable. You've heard the story of people losing everything, homes, cars, filing bankruptcy and losing the ability to have low interest payment options, etc. Risk dramatically affects a person's lifestyle. The amount of income you make is directly related to the quality of things you can afford to purchase. In a serious turn of events, you may have to sacrifice a large lump sum of your income, leaving you to fend for yourself financially. Many Americans fail to save even $1,000 for an emergency. Once your savings is gone and your income is cut, you are in financial danger at that point. You could end up homeless, begging for money or support from the bankrupt government. Is this a quality of lifestyle you would enjoy living?

Looking at another aspect of risk is retirement. Most plan to retire at an old age and then settle for an income half of what they brought home during their working years. This plan is absurd and should never be your option. The quality of life you lead after working should be 100% better than the one you led while actively creating the income. At the least, you should never agree to let yourself live on an income lower than you made while working in a job or active business. A lot of mistakes were made with retirement planning before the crash and in 2008, a lot of Americans watched their retirement plans go up in smoke with the crashing market. Ironically because the wealthy had a higher financial intelligence, they seemed to still make billions of dollars. This is the consequence of failing to minimize risk as well as the reward for hedging, which i'll explain shortly. The working class paid consequences and the wealthy got rewarded. Both parties got what they planned for. In order to see into the problem and understand the solution let's break down the components of risk. To keep it simple let's focus on the important parts. Your probability of loss and minimizing risk.

Your Probability of Loss - Also know as the odds. By definition probability of loss means how likely is it that you will lose. In order to make it visible mathematicians came up with the odds. A percentage that tells you how probable you are to win or lose. In the casino and lottery the odds are always to the house. Meaning the odds of you winning is very low. Financially you must know what your odds are in order to know if they need to be adjusted. Personally I don't figure out the odds for every situation. Its better to know what you have at stake, if its at risk at all and then if the risk can be minimized. When you look at your probability of loss and hope for the best you are taking and uncalculated risk that be detrimental to your financial future. Instead of going in blind, look at what's at stake and partner with successful professionals to help you determine your probability of loss. The best question you can ask is "How will I lose? What are the biggest problems you find other people having?" Taking these questions to professionals can reveal risk factors that are usually overlooked. When you understand all of the things that can cause you to lose, you are now aware of what you need to focus your risk assessment on. Always make it a point to know HOW you are at risk and put a plan in place to minimize or eliminate the risk altogether.

Hedging - By definition hedging means to limit or qualify (something) by conditions or exceptions. In another way that's easier to understand, hedging is used to protect yourself from risk. The definition says to limit by exceptions or conditions meaning you set parameters that have to be met before something else happens. A great example is hedging a bet. When you hedge a bet, you place more than one bet. One bet goes with the odds and the other bets may go against them. If you wanted to bet on a boxing match you would place the bigger bet with the fighter winning but you would also place a few smaller bets with fighter losing. The one you favor the most being for the fighter to win and the one you favor the least being the fighter loses. If the fighter loses you don't lose as much from the original bet you place but it must be enough to cover what you couldn't afford to lose. Lets do a practical example:

You bet $5,000 that your boxer will win with odds of 3 to 1. This means if you win you get 3 times your bet which is $15,000.

You bet $2,000 that your boxer will lose and odds are 2 to 1. This means if your fighter loses you get 2x's your bet which is $4000

Here's how you organize this information. Before you bet you know you can't lose more than $3,000. That was the maximum you were willing to gamble away. You always find the cover or hedge position first in my opinion. This will be sure that you have your safety money in place before committing to larger amount. This is now eliminating risk altogether. Why? You decided what you didn't want to lose and you put a hedge of protection around it now you walk away without losing more than you wanted to. Now lets see what the numbers above show us about this bet.

We set a minimal loss of $3,000 (This was our Safe Money we didn't want to lose)

We invested a total of $7,000 against both positions. Our main position of winning $5,000 and our hedged position of losing $2,000.

We have the possibility of making $15,000 if the fighter wins. This is a profit of $8,000 and the reason we bet in the first place.

We also now eliminate our risk of losing our safety money which is $3,000. We are now only risking investment money we have saved up and can afford to lose.

In the end our position is to sacrifice $3,000 for the possibility of making $8,000. And this my friend is how you minimize risk by hedging. I used the numbers above as an example however there are many ways to hedge a $0 loss. I wanted to leave the option open for my readers to submit examples of a $0 loss position to show their understanding. This will help you master the concept and bring your awareness to a higher level. If you are not a numbers person, that's ok, use a calculator and simple addition to achieve these answers. No complicated formulas are need. You only need to know WHAT you are trying to protect from risk and what you want to invest. The rest will work itself out. For further help, please join our "Financially Empowered" group on Facebook.

There are many ways to minimize or eliminate financial risks to your money. The first step is uncovering where they are. Be diligent in finding how your income is at risk right now and get to doing what's necessary to minimize or eliminate it. The main areas to look for risk are:

Your earned income from work - How can I protect what I earn from my employer?
Money that is invested for you in stocks and bonds - How can I protect my investments in my long term accounts like 401ks and IRA's?
Money that you invest into stock, bonds and options. How can I protect myself from losing money with my investment strategies? What systems minimize my risk and maximize my gains?