Heads-Up: Upswing Resilient Investor Guide - Risk Severity Matrix

 


Let’s focus our attention on Risk that involves multiplying the loss/impact/severity and likelihood or probability [16]

Risk = Impact * Likelihood,

where Likelihood is the possibility of a risk event (negative or smaller than expected return) occurring, whereas Impact signifies beneficial or harmful effect of a risk event on the investment objectives. According to the proposed TLS, we will define the following Likelihood and Impact Low, Moderate and High scores.

Table 1 shows that the risk severity matrix is a square containing 9 colored boxes in a 3x3 pattern. On the left are the Likelihood Levels, which is how we rate the likelihood that the event will happen. On the top are the Impact Levels, or severity if the event occur. Likelihood and related Probability P goes from Low (at the top left) to High (at the bottom left):

Level 1 (Low) Not expected, but possible (P~0.25+/-0.2);

Level 2 (Moderate) May occur sporadically (P~0.5+/-0.2);

Level 3 (High) Likely to occur soon and repeatedly (P~0.75+/-0.2).

 Impact goes from Low (at the top left) to High (at the top right):

Level 1 (Low) Risks have minimal financial damage or long-term effect ;

Level 2 (Moderate) Risks may cause acceptable minor loss but little overall effect;

Level 3 (High) Risk will cause significant loss and long-term effect.

Example Impact (Level 1): you are at risk of losing less than 5% of your assets;       

Example Impact (Level 2): you are at risk of losing up to 10% of your assets;       

Example Impact (Level 3): you are at risk of losing much more than 15% of your assets.    

Example Probability (Level 1): less than 25% of your stocks are with negative ROI;       

Example Probability (Level 2): around 50% of your stocks are with negative ROI;       

Example Probability (Level 3): more than 75% of your stocks are with negative ROI.    

We can use this approach to calculate whether decision mistakes (wrong investments/trading) will happen, and if so how destructive the effects could be. This is why we use a numbered scoring method and color-coded indicators. Our scoring is done when we select a level of Impact (1 to 3), and a level of Likelihood (1 to 3). A score is determined by the product (multiplication) of the two numbers. This number is associated with a 3-level scoring result (Low, Moderate or High).

Here are all the possible results:

Low Risk (a score of 1 to 2) — Highly attractive deal with the optimized RRR and full control;
Medium Risk (a score of 3 to 4) — Acceptable deal for long-term low-return investments;
High Risk (a score of 8 to 9) — Unacceptable deal, investigation and monitoring needed.
For example, NFLX and ALB may be considered as low-risk stocks; long-term investors can benefit from medium-risk ETFs such as VIG, IDV or SCHD; overvalued TSLA, fossil-energy XOM and IBM tech seem to be high-risk stocks. Disclaimer: this might be valid for 2021  as a  learning example, and you are most welcome to have a different opinion and propose your own decisions, of course. 

Table 1: Example Impact versus Likelihood Risk 3x3 Matrix

0 Risk-free index

 

Impact

 

Likelihood

1 Low

2 Moderate

3 High

1 Low

1

2

3

2 Moderate

2

4

6

3 High

3

6

9

 

The example shown in Table 1 could illustrate the task of choosing your investments as  representing (1) unacceptable high risk returns like crypto assets or crowdfunding, (2) low risk options suitable for long-term and low-return, -volatility investments (corporate bonds, ETFs, etc.) and (3) RRR optimized portfolios suitable for the S&P 500 Dividend Aristocrats

Comments

  1. What are the Risks Associated with Investments?
    Here is the summary of the risks associated with your investments:
    No Risk Comment
    1 Price Related to the price of your product, the value could drop.
    2 Market Volatility = rapid market swings due to mood changes.
    3 Concentration A lack of portfolio diversification when you have only a few types of investments
    4 Default This is for bonds only: the lower their credit rating, the higher the interest will be.
    5 Currency Currency exchange rates have a great impact on the dollar value of your product.
    6 Interest If interest rates rise, share prices or fixed-rate bond prices will drop.
    7 Liquidity It might be difficult to sell your shares because of low demand.
    8 Politics Government measures* can decrease the value of your products
    9 Inflation The dollar value of your investment will decrease with non-zero inflation
    10 Reinvestment This is for bonds only: you may be unable to reinvest your product in a bond with similar features.
    11 Unforeseen
    events Terror attacks, pandemics and drastic changes to legislation* can decrease the value of your product.
    *Brexit, the Biden era, GDPR, etc.

    ReplyDelete
  2. Key Takeaways
    The ultimate goal of all investors is the ratio min(Risk/Return)=max(Return/Risk)
    The Traffic Light System (TLS) is the all-in-one way to classify the Return/Risk Ratio
    The Risk Severity Matrix is the product Impact * Likelihood of high-risk events
    The TLS assigns the Low, Moderate and High scores to the event Impact/Likelihood
    The Impact versus Likelihood Risk 3x3 Matrix consists of three risk levels L, M and H
    The investment decision score is Green (accept), Amber (research) or Red (reject)

    ReplyDelete

Post a Comment

Popular posts from this blog

Appendix B: More Real World Examples

Max(Reward) Control

Heads-Up: Upswing Resilient Investor Guide - Min(Risk) Control