LEVERAGE AND RISK ASSUMPTION
Most people seem to grasp the not so simple risk reward aspects of leverage at least in a general way but the whole area of risk tolerance is not something that the human mind grasps well.
Humans (and for that matter dogs) have been evolutionarily conditioned to both accept and avoid risk but not to risk quantitatively. Humans will die (take stupid risks) for their children, dogs for their masters. Both genetic instincts are very good for the survival of the human race (and even for the huge dog population that rarely has to commit suicide for the survival of the species that manages to get fed without having to go hunting or die to protect their masters).
Financial risk has not had much hand in human evolution. Our species has been more concerned with avoiding falling from high places and getting incinerated in the campfire, or in a little more long-term planning wise reproducing. (Population levels are however declining, one theory being that the cost of educating children makes parents have only one child (especially apparently in Korea.. Niall Ferguson has observed that we may be the only species destroying itself by educating itself.)
Dog's learning to die for their masters is an impressively complex and probably rapid evolutionary progress, having taken but a very small fraction of the time that various species have evolved to die for their children.
Actuarial science and the insurance industry have evolved of the necessity to spread the huge risks of sending ships on perilous voyages. The returns could be huge, but there was always a good chance of losing the ship. Judging the risks was extremely difficult: weather, acts of war, deferred maintenance of the ship, skill of the captain...
Get a high enough premium and any risk is worth the INSURER accepting the risk..
Get a low enough premium and any risk is worth the INSURED shifting the risk..
Leverage shifts the risk (and the reward!!) to the equity holder and away from the debt holder.
The human mind however without using statistical assumptions is incapable of determining when to accept and when to shift risk.
Credit default risk and stock options are two types of financial risk sharing that work fairly well.
The risk of being over leveraged in real estate is, however, difficult to ensure against directly. For a corporate tenant credit default coverage may be available, and sometimes is even underpriced.
Performance bonds can be obtained to offset the risk of sub-contractor default.
Earthquake insurance is generally prohibitively expensive.
Fire and multi peril sometimes reasonably priced, sometimes prohibitively expensive.
Builders risk may provide real protection or more often just illusory protection.
Construction risk can be shifted to custom buyers or to the owner of the land.
领英推荐
Avoid all risk and get paid anyway and you get very rich.
Accept unacceptable risk and fail to grab the golden ring and the ride is over.? No problem if you can afford the price of enough carousel or roulette tickets.
Leverage is simply the undertaking of more risk in pursuit of greater gain.
The sailors and fishermen who sailed on risky voyages had to take ultimately leveraged risk of life itself to feed their families. A high pecrentage drowned. They could not get reasonably priced life insurance.? The ship owners however could share their risk.
Starting out most people have nothing to lose but their time or their lives (all their time). They are well advised to take acceptable risk and invest in diversified stock portfolios, even fairly speculative investments. An old man? with a lot of money he can never spend does not have much risk tolerance, and corresponding less reason to take risk and should be content with a safe return.
Consistently correctly evaluate the right risk reward ratio and you will, with a fair dash of luck, die rich.
#leverage
#realestateinvesting
#risk
#riskreward
#riskacceptance
#riskshifting