By Brett Sherman, The Sherman Law Firm
Frequency and Magnitude of Risk
In finance, risk is the chance that an investment decision or strategy will result in loss. Any analysis of risk must consider two major elements - FREQUENCY OF LOSS; MAGNITUDE OF LOSS.
Frequency refers to how often one can expect losses. Magnitude refers to the size, or severity, of potential losses.
Some risky investments will produce losses more often than others. This is not necessarily bad for the investor.
Suppose strategy X results in a $10 loss 80% of the time, but a $100 profit 20% of the time. So, 8 out of every 10 times you attempt the strategy, your expectation is that you will lose $10, for a total loss of $80 dollars. However, if your expectation holds true, you also will make $100 twice in every ten tries.
Strategy X, is risky from a frequency standpoint since most of the time, the investor losses money. However, as long as the investor can afford to take losses and keep investing, Strategy X is a pretty good gamble since - on average - it can be expected to produce a net profit of $120 for every 10 times the strategy is used.
By the same token, some investment strategies have a very low risk frequency (they will not lose money very often), but can still be extremely risky.
Suppose Strategy Y produces a $10 profit 90% of the time.
A 90% success record sounds really good. But, if 10% of the time Strategy Y results in a $500 loss, the strategy's risk magnitude (the huge size of infrequent losses) far outweighs the potential upside of its low risk frequency. On average - it can be expected to produce a net loss of of $990 every 10 times the strategy is attempted. Strategy Y is a terrible gamble.
Now, suppose that Company Z used Strategy Y for 5 years. All 5 years were profitable. This is not surprising, since there is a 90% expectation of success. The Company proudly points to its record of success each year. Of course, each year Company Z sticks with this strategy the odds of a $500 loss grow higher.
In year 6, the Company's luck begins to run out. It loses $300, not as bad as the expected $500 loss, but enough to put Company Z in serious trouble. In year 7, the Company decides to stick with Strategy Y. After all, the investment strategy is almost always successful. Unfortunately, year 7 is another bad year for Strategy Y - a full $500 loss.
The size - or magnitude - of the loss is catastrophic. Company Z cannot recover. The Board of Company Z salvages some value by selling what is left of the Company to Bank of America.
RISK MAGNITUDE - CONCLUSION
Wall Street investment banks like Lehman and Bear Stearns gambled on a strategy that focused on mortgage-backed securities during the housing bubble.
The risk magnitude of their strategy was the possibility, and ultimately the reality, of losses so catestrophic thatLehman and Bear Stears are each out of business.
There was no "perfect storm" needed to bring down Lehman and Bear. All that had to occur was the very predicable collapse of subprime mortgage industry.