Managing Risks

We all take risks.

“Risks are events or conditions that may occur, and whose occurrence, if it does take place, has a harmful or negative effect.” That does not sound good, and most rational human beings would like to figure out how to manage risks.

Before thinking about how to manage risks, it is very important to classify them into two categories: involuntary or voluntary and recognize that they need to be managed differently.

An involuntary risk is that associated with event over which you have little or no control. Lightening strike, car accident, health and house fire are some of the examples. Eliminating this type of risk has no negative consequences, and generally one can purchase an insurance to cover these risks.

The goal of an individual’s risk management strategy then should be to reduce overall involuntary risk to an acceptable level at a minimum cost. How does an individual manage the risk of his house burning down? Purchase an adequate coverage at minimum cost.

A voluntary risk on the other hand, is that associated with activities undertaken voluntarily, as the name would suggest. Ice climbing, diving, investing in stocks, and purchasing a house are examples of activities that involve voluntary risks. These risks are acceptable because they are by-products of activities that create benefits. Ice climbing creates pleasure, so what if there are risks involved? Generally, insurance firms will not cover these risks.

The goal of an individual should be to maximize overall benefits while taking acceptable risk. When put in practice, this would imply reducing the risk for a specific activity, of course. One should not attempt ice climbing without crampons. But it would also imply adding risk if the commensurate benefit outweigh the additional risk. Sitting home may be safe but could also be very boring!

So the strategy for managing risks that we face boils down to:

• Reduce the involuntary risk to an acceptable level at minimum cost, and at the same time,
• Maximize the benefits provided by voluntary risks while taking acceptable risk overall.