The Difference between Risk & Loss
Risk Management has caused many people to substitute one four letter word for another. They will use the word RISK when they should be saying LOSS. And there is a world of difference between the two. It is the difference between the gleam in eye of the loving newly weds and the cry of the babe in the middle of the night. (Really dating myself there. That is one from a 1950’s movie.)
A RISK is a potential for a LOSS. The LOSS is the realization of that negative potential. A RISK is running across a busy street blindfolded. A LOSS is getting hit by a car while doing that.
All RISKs do not result in LOSSes and all LOSSes do not result from RISKs.
A RISK is putting a revolver with one bullet up to your head and pulling the trigger. A LOSS is the result of the chamber with the bullet being fired. A RISK without LOSS is when you pull the trigger and the hammer hits an empty chamber. A LOSS without RISK would be putting a revolver full of bullets up to your head and pulling the trigger.
So if someone asks you what you intend to do when your RISK limit is exceeded, you have choices. One of those choices is to ignore the breach and hope that you are fortunate. Those who make that decision and do not find that RISK turning into a LOSS will go down as RISK geniuses. Those who find themselves facing a LOSS that is larger than they can bare will be thought to be dunces.
Other choices involve the many ways that one can use to reduce the frequency or severity of the RISK, to bring it within your limit. But even if you do take those choices, your reduced RISK may still make a LOSS. If your evaluation of the RISK was correct, then the reduced RISK may not make a LOSS that exceeds your limit. But if your estimate of the RISK was incorrect and you have a LOSS, then the LOSS may be larger than your limit, even if you carefully followed procedures to reduce the RISK.
But if someone asks you what you intend to do when a LOSS exceeds your limit, that is an entirely different story. The choices there are few. The LOSS has happened. You should then (a) learn to live with the consequences of the LOSS that you were trying to avoid by setting the limit and (b) try to learn the cause of the loss that exceeds your limit and discern whether you can make changes that will help you to avoid such situations in the future.
Learning to live with the consequences of the LOSS may well mean adjusting your risk limits to the lower risk buffers that you may now have access to. The opposite of learning to live with the consequences is the destructive but common practice of “doubling down”. When a gambler “doubles down” after a loss they are hoping to make back their losses with their next bet. Traders are sometimes prone to this thinking. They conclude that such behavior is the only way to save their job after a large loss. Often such actions lead to the opposite consequence for the trader.
Learning from the LOSS means means tracking down whether the excess LOSS resulted from excess RISK taking, RISK measurement error or results from a predictable but highly unlikely event. The excess RISK taking can be from failure to follow procedures including the failure sited above to act once a breach of limit is found. Other failures can be seen from Jared Diamonds excellent analysis of failure.
However, when answering these questions, be aware that sometimes folks have started to use the word RISK when they should be using the word LOSS. One person recently was talking about their risk management program and went so far as to say “realization of the negative potential of a risk” when they meant LOSS.