**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. **

**STRATEGY X**

**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. **

**STRATEGY Y**

**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. **

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