Imagine going to a casino to play some blackjack.
You convert your money into casino chips and start playing.
With blackjack, you get to choose how much you want to bet on a particular hand.
The amount you win is related to how much you bet.
Bet a little - win a little. Bet a lot - win a lot.
The opposite is also true, though. The amount you can lose is related to how much you bet. If you bet a little - you only lose a little. If you bet a lot - you lose a lot.
Even if you lose, you can always keep playing...unless you run out of chips. Once you run out of chips, you're out of the game. You can risk a lot of money to try to win a lot of money, but if you risk all of it, you run the risk of eliminating yourself from the game.
There's a lot to learn from this analogy about our financial lives, but there are some life lessons, too!
Two sides of risk
Risk is, essentially, the chance that something we don't want to happen will happen. In investing, risk is the chance that you'll lose money. In life, risk is the chance that you'll get injured.
Risk isn't just one thing, though. There are two sides of risk. The first is the chance that something bad will happen. Statisticians call this the probability of it happening.
If I'm far enough away from a ledge, I have a small chance of falling off the ledge.
On the other hand, if I'm right on the edge, it's a high risk that I'll fall off the edge.
The chance of risk showing up says nothing about the consequences if it DOES show up.
I might have a high likelihood of falling off the ledge, but if the ledge is only a foot off the ground, the consequences are low.
If the ledge is the top of a skyscraper, the consequences are very high.
Multiplying by zero
If the consequences are high enough, it's like multiplying by zero.
Let's have a quick maths lesson (skip to the next session if you hate maths!).
Multiplication is, essentially multiple additions.
Take two times zero.
This says that you add zero two times.
There are two zeros being added, and since there are no numbers besides zero, the answer is zero.
The same is true if we multiply by a larger number, like five. Five times zero is adding zero to itself five times. The answer is still zero.
It's the same story with a million. Adding zero to itself a million times will still give you zero.
It doesn't matter how big the number is.
Multiplying by zero will always give you zero.
Stay in the game financially
What's all this math stuff have to do with risk? Well, it doesn't matter how much money you have. If you engage in a multiply-by-zero event, you're out of money.
Our intent should be to avoid multiplying by zero. In the language of risk, we want to avoid devastating consequences.
For example, you might invest a little bit of money in, say, your friend's start-up.
If the start-up doesn't pan out, then you're still okay because you didn't invest too much money.
If, on the other hand, you invest everything you have...
You're broke if the risk shows up.
This is true no matter how likely it is. If the worst-case scenario is a multiply-by-zero event, you're out of the game.
Stay in the game...full stop
This goes beyond just our money. It's true of life, too.
Say you want to partake in a potentially dangerous experience. It could be anything, like skydiving, cliff jumping, running a marathon, engaging with someone experiencing road rage, trying to pass someone on a busy two-lane highway, or even skiing on a closed part of a mountain.
You have to consider the consequences of what happens if the risk shows up.
If the worst that can happen is that you get a few scrapes and cuts or even a broken bone, then you're probably okay.
But if the worst-case scenario is death, then you're out of the game. You don't get to experience any more life.
Avoid multiplying by zero.
This isn't to say that you should take risks.
Risk and reward are related.
It's also not to say that you should be scared of everything.
This is just a reminder to stay in the game, keep investing systematically, and keep enjoying life.
