The Relationship Between Risk, Reward, Edge, and Risk Management
Risk is the potential for loss. A reward is a potential gain. Because we see risk and reward in many parts of life, we all have an understanding of these concepts and how they are two sides of the same coin. For this article, we will focus on financial risks and rewards since that is our specialty here at Quartzite Risk Management LLC (Quartzite).
People often tell me that to make money (earn a reward), they need to take a risk. However true that statement may be, it is not the whole story. If one wants to make money in the long run, one needs to take quality risks in the right amounts and minimize lousy risk. For example, consider visiting the local casino — here, you will find ample opportunity for bad risks. On any given day, this visit to the casino might result in a winning day for you, but repeated visits will almost certainly result in net losses. The opposite is the case for the casino, which may lose to any given player on any given day, but will rarely, if ever, suffer a day of net losses. The more visits the casino gets, the more likely it is to win overall. Casinos are profitable because a bad risk for the player is a good risk for the casino. Casinos almost always have a mathematical advantage built into their games – or what we call edge.
Edge is an advantage. There are lots of ways to have an advantage. Knowledge, skills, and ability come to mind, but they are just a few examples of many. Edge alone cannot guarantee success in the short run. On its own, having an edge does not ensure success over the long term. Accumulating more edge usually involves adding more risk. If one adds too much risk, one runs the risk of being wiped out of the game. This risk of ruin can occur regardless of how much edge one had. One way casinos protect themselves from going out of business is by limiting the amount players are allowed to wager on a bet. Casinos also protect themselves by diversifying their risk across as many players as possible. Both limiting individual exposure and diversification, when available, can be excellent tools for managing risk.
Risk management is the process of identifying, quantifying, and then mitigating risk. When properly-done, risk management allows one to accumulate more edge while keeping the accumulated risk within acceptable limits, thereby reducing the chance of being wiped out. There are many tools for managing risk, like diversification, position-sizing, and hedging, for example. These tools, in a sound combination, can help businesses survive unanticipated events and uncertain times. The longer businesses stay viable, the more edge they can accumulate, and the more rewards on which they can potentially capitalize. Longevity is one value that a risk management strategy provides.
Quartzite manages risk. It’s what we do, and it’s who we are. We take it seriously because even reasonable risk, when not handled properly, can have bad results. At Quartzite, we strive to help our clients manage risk and keep them in the game for the long haul.
For a more in-depth and mathematical discussion of these ideas, see “Coining Some Terms.”
Readers should note that there is always a risk of loss in trading futures or options, and that no risk management strategy can entirely mitigate every risk.
