Risk vs. Impact
I was listening to Mohammed El-Erian, CEO and co-CIO at Pacific Investment Management Co., (PIMCO) on Bloomberg Radio the other day and he made an excellent point about risk, probability and outcome that I thought I would pass along as this is a key to our investment practice. He puts the risk of deflation around 25% now, which while noteworthy, isn’t exceptionally high. The potential consequence to investors of deflation however, is so significant that even a slight increase in this risk ought to get everyone’s attention. You can think of it this way, the risk of dying when bungee jumping off a particular bridge is say, statistically 5%. That risk increases to 7% if the jumper does not check his gear adequately. An increase from 5% to 7% wouldn’t be terribly interesting if we are talking about the risk of getting pummeled in a paintball game, although my ego might be bruised, and my fantasy of being a deadly international spy once again squashed, but the real long-term consequence is minimal. Now if the risk of actually dying increases by 2%, I’m going to pay some serious attention. When thinking of risk, you must also consider the magnitude of its impact on you if that risk becomes a reality.
