On weekends, we often go hiking, kayaking or swimming. Some of the activities are risky. Why do we enjoy risky activities? Why not just stay at home, which is much safer?
Much of the rewarding activities involve risk, such as exercising, hunting, wars, military, political or business wars. That is why we instinctively love many risky activities. We often try to reduce risk. In some places, there is a legal requirement to put on helmets while biking. This reduces bike injury. At the same time, this requirement discourage many people from participating biking. That is why biking in North America is not as popular as in many other places, where regulation is not as tight. Nowadays, there’s less enforcement on helmet wearing in some parts of North America to encourage broader participation of biking.
In businesses, does reducing risk always provide better outcome? Let us look at the risk management practices at Barrick Gold, the largest gold mining company in the world. Barrick Gold used to hedge its gold project with futures contracts, which greatly reduce its risk exposure to gold price fluctuations. This practice insulate the company from the decline of gold price. But this practice also insulates itself from the rise of gold price. In the end, Barrick Gold unwinded all its futures positions, at great cost.
Reducing risk exposure used to be a popular practice. But more and more companies realize that reducing the exposure to risk also reduces the exposure to profit.
Forest fires occur very often in nature. We actively extinguish forest fires to protect property and life. As a result, forests often accumulate a lot of dead wood and old trees, which are prone to fire. When we try to extinguish every small fire, this could lead a large and difficult to control fire in the end. Similarly, we take many measures to reduce personal and professional risks for the members of our society. The reduction of everyday risk could leads to large and difficult to control risk in the end.
Next, we will turn our attention to personal finance risk management. When we take on a home mortgage, should we take a fixed rate or a floating rate mortgage? Many people take fixed rate mortgages, for they are perceived to be less risky. However, fixed rate mortgages are essentially an insurance, with the attached insurance cost. Most of the time, total payments from a fixed cost mortgage are much higher than that from a floating rate mortgage.
Today we are forced to pay higher and higher rate for car insurance, house insurance, pension deduction and many other deductions. More people view insurance as a burden instead of a risk management tool. When there’re too many risk management practices, the cost of risk management itself becomes a big risk.