The Education Of Risk
By Melvin J. Howard
Ask yourself "What is the defining feature that lies at the
heart of capitalism?" To that question many people would probably answer
"profits". But it may be more correct to say that it is
"RISK". Profits are compensation for taking risk. In a capitalist
economy, individuals with accumulated capital either spend it on something real
or invest it, which really means lending it to some economic venture. When you
invest your money, you are putting your capital at risk for you might lose some
or all of it. Investors are compensated for this risk taking by the potential
for profits.
This potential for return provides the incentive for risk taking,
and it is this risk taking that has led to phenomenal economic growth in market
economies. One of the downsides of the system is that individuals are required
to bear many of the risks of daily living themselves. The risks of devastating
events like unemployment, sickness, accident and loss of housing. In our
current economy, some of this is alleviated through government safety nets and
the insurance markets, where risks can be transferred, but for a price. As
government safety nets shrink and more people find adequate insurance coverage
prohibitively expensive, it becomes increasingly important for individuals to
develop their own contingency plans. In a market economy, each player would do
very well to understand how to manage his or her risks, and how to take
calculated risks just putting your money in a regular savings account just
won’t cut it anymore. As we have seen in this economy you should have a backup
plan. Check your pension plans make sure the company is on solid footing
(remember Enron and World Com) or at least make sure the fund is segregated.
Amazingly, many people do not pay much attention to this ever
changing, ever elusive beast that runs so much of our lives. Risk is sneaky it
influences everything we do, most people don’t realize there is risk in
everything we do in life whether for love or money the risk if you don’t and
the risk if you do. Risks also likes to take the credit (or the blame!) for it.
Risk can lead to untold wealth it can take you from rag to riches and back
again. More is required then fate and destiny so over the past thousand years’
various tools developed to measure risk and for humans to take some control of
this wild beast. These capabilities ultimately lead to our capital markets, and
our modern monetary system and it's financing of the industrial and
technological revolutions that followed.
Developments in Mathematics and developments in finance have been
inseparable since the days when merchants would use an abacus to calculate their
trading gains. But perhaps the real turning point occurred somewhere along the
halls of Baghdad about a thousand years ago. While Europe was going through the
Dark Ages, an Arab mathematician named Al-Khowarizmi (hopefully I have the name
right) laid the foundations for basic arithmetic and algebra we use today, upon
which most subsequent mathematical theory would later be based.
And part of his motivation was quite simply practical to
facilitate trading. Imagine how things would have progressed if, instead of
this development, the world had stayed on the old Roman and Greek numbering
systems, adding them up with an abacus or pebbles in the sand! It must have
been at this point that risk was getting nervous that soon, not only would it
be noticed, but also humans might try and use it to their advantage.
As Europe woke up from its dark era and the renaissance began, the
Europeans built on these developments from the Arab Mathematicians and the
equipment for dealing with risk and the mathematics of finance began to
develop. Initially, probability theory was born mainly as a result of wealthy
men's fascination with games of chance. Accounting theory developed in Italy
and facilitated the flow of capital into business ventures. Then the
mathematics behind insurance (or actuarial science) began to develop to help
manage the risks of overseas trade and financing vehicles such as annuities
issued by the English government to finance their budget deficits. Over the
centuries the mathematics behind trade and finance has developed as a tool to
help investors take calculated risks and get capital to flow in the direction
of economic development, rather than catastrophic loss.
Finally, the late twentieth century saw the ultimate formalization
of the practice of "risk management", and today there are tools to
help us manage the risk/return trade-off for just about any risk we can
imagine. For a market economy to be somewhat fair in providing opportunity, all
market players must know how to play and must be able to make sensible risk
return trade off decisions. Where you have large segments of society that
participate but never really learn how to play, then they will be preyed upon
by the more knowledgeable players.
"Even more important than money it is information about money.”
Just as in a sports game it's important for each player to know the rules of
the market game and to learn some skills and strategies to get to their desired
outcome. Also of paramount importance is to have some information on how other
players are going to play the game. Information is money.
Deregulation in both the financial and gaming sectors over the
past few decades has created a situation where the more sophisticated players
can play directly against those that never even learned the rules of the game,
let alone strategy. And so over the past two decades we have seen the rapid
rise of things such as predatory lending, credit card, banking and investment
fraud. All of these create a transfer of wealth from the poorer to the richer,
based on the knowledge gaps between the two groups. Capitalist economies have
tried to prepare people for a life in the market economy through their
education systems but that has not worked out so well everybody now days wants
to be a rock or rap star. Or pitching their new reality TV show they want fame
and fortune now. They do not have time to learn just a little on how the market
system works. Capitalist have also tried, in varying degrees, to provide a
safety net for those who do not have the ability to withstand the risks of
disability, illness, unemployment and so forth, to prevent them from being shut
out of the economy.
But government funding for this safety net for handling risk and
for the education system is shrinking as states face budget crises and as
federal spending is increasingly diverted to other branches and banking
bailouts. And more and more it seems that the funding gaps are to be funded by
the winnings of this market game played by the skilled players against the less
educated players, just as the latter becomes more tempted towards games of pure
chance to change their situation. Statically most people who win lotteries lose
all their money within a few years and actually end up in debt, while people
whom took the time to educate themselves on finance and the free market economy
made Millions out of nothing repeatedly. Nothing in this life is risk free but
remember "He who is not courageous enough to take risks will
accomplish nothing in life."
