How do YOU define Risk?

Question

Thought I would start a thread to see how different people define risk and take it into consideration.

When I was in Grad School one of the finance advisors, who also manage money for other people, defined risk as "The likelihood of not achieving your goals".  To this day I think this is the single best definition of risk I have heard.

To start with you have to have a goal.  I have friends who will tell me that have money in CD's because they  are afraid of "risking it" in the market or real estate.  In the next sentence they will tell you they are worried if they will ever be able to retire.  This is a classic example of conflicting goals safety vs. return.  It is also a good example of how an over emphasis on safety can guarantee a higher risk of failure (inability to retire).

For me my goal was to get out of corporate America so I quit my job and did rehabs for about a year, then pivoted to notes where, so far, we have enjoyed solid returns.  Is there risk in notes?  Yes!  But we think we have a manageable amount of risk and have established a portfolio so we are comfortable with the idea that if one note goes bad we will still be OK while we work out the issues.

So how do YOU define risk and what factors into your equation.

Mike Hartzog · Answer

My perspective is that one must define the scope of the risk they are talking about to have a meaningful conversation about it.  One key risk in investing of any kind is loss of capital. For me that's the baseline risk I want to mitigate for.  Once steps are taken to ensure working capital is safe, there are other risks you can pile on top of that one, i.e., risk to returns.  If capital is invested for a period of time and the return is very low or zero, your loss is the opportunity to have invested the capital elsewhere for a better return.  There are also risks that are more of a personal nature, for example, reputational risk of you don't conduct yourself ethically and with integrity in your business interactions.  Risk to personal relationships caused by focusing too much on business.  The list goes on...

Marcus Ware · Answer

Plain and simply, anything that you are willing to take on that can compromise your investment.

Kevin Page · Answer

@Mike Hartzog  I agree. I would define it as the risk of capital but there are varying degrees of risk. Some deals are riskier than others. The more deals you do the more comfortable you are in evaluating and taking a risk.

Mike Hartzog · Answer

I should have mentioned that if you REALLY want to define risk, doing a traditional risk analysis is one way to get there.  This involves thinking of all of the potential risks associated with a particular investment or project and defining the following for each:

• Risk - Give it a name
• Event(s) - What event or events could cause the risk to become an issue
• Likelihood - What is the likelihood that the event(s) will happen.
• Impact - If the event(s) happen, what is the impact
• Mitigation - What mitigations can you put in place to lessen the likelihood or reduce the impact.

This type of analysis allows you to focus first on defining mitigations for your most likely and most impactful risks.

Joe Villeneuve · Answer

This is a great topic for discussion.  I think this one item, "risk", and each investor's definition of that word, is what decides the direction most investors take. Furthermore, I believe our individual definitions are based on how much control or influence we have in the direction we choose. If, in our individual systems, based on our markets, we are able to control risk, or influence results, we find that particular risk, well...less risky.

Some of us fell that we have more control/influence over negative cash flow in our systems/markets, so using leverage ti the max isn't considered as risky to us.  This is because if something negative happens (CAPEX, vacancy, missed rent, etc...) we feel we have it covered.  We see the risk in losing our equity, or losing the use of our equity, by having it stagnate in a house.

Some of feel that by leveraging to the max is more risky to them, because they don't have the control/influence needed to reduce the risk.

Some feel that taking on someone elses problem (NPN) isn't risky since they are able to have a series of controls in place to either sell, repair, or rewrite the non-performance.

Still others have more control over flipping since their market and their rehab abilities dictate more control there.

It isn't the direction you take to invest that's risky.  It's taking a direction where you have limited knowledge, control and/or influence that makes it risky.  Which is probably why there are so many different opinions on this topic, and why all the opinions are probably right...for the investor with that opinion in their market.

Bryan N. · Answer

If I'm going to lose sleep when the $hit hits the fan is how I define too much risk for me.

Jon Holdman · Answer

For analyzing investments the standard definition of risk is what your financial advisor said.  Its defined as the range of possible returns.  With a CD, the return is defined when you buy the CD and guaranteed by the FDIC, which is effectively the US Government.  Neglecting the possibility of a complete collapse of the US, because that really would apply to most assets most investors might put their money in, you WILL get exactly that return and you WILL get your principal back.  So the risk is zero.

OTOH, if you invest in a stock, there might be a possibility of, say, a 5% annual return from dividends and appreciation.  But there's a the stock may go down.  So, while there is the POSSIBILITY of a higher return than the CD, there is also a very real possibility the returns will be less than you expect, or they might be negative (i.e., you lose some of your principal.)  You could lose your entire investment.

Leveraged real estate is even higher risk.  You may get big returns.  For instance, I have a house I paid $61K for in 2008 and put about $19K into it.  I bought that using a hard money loan, and then refinanced into a conventional loan, so I had about $15K invested up front.  Since then its generated cash flow, but also had a few big expenses, so, I might have about $10K on net in this property.  Based on other sales, I think it would easily sell for $130K, maybe more.  So if I netted maybe $120K on a sale, and paid off the $70K I still owe on it, I would have $50K, before taxes.  Woo Hoo!  That's a 5X gain on the money I have in it.  That's something like a 25% annual return.  (Note, I realize this is a really dirty an inaccurate calculation).

But we could have had prices continue to drop.  This happened to me on another investment I have in a mini-storage.  It happened to a lot of folks who bought between 2002 and 2007.  With leverage, a price drop means you can pretty easily lose your down payment, and then start going underwater.  So, unlike the stock, leveraged real estate can not only result in a 100% loss, but the loss can be even bigger than that.

That's a high risk investment.  High risk => a wide range of possible returns.  No investors going buy into a deal that says you might make 2%, but you could have a loss of 20%.  So, to get an investor to buy into a deal that offers a 20% loss, you better have the possibility of a return that's a lot higher than 2%.

How do YOU define Risk?

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