Risk has two components:
For there to be risk, both must be present.
If you swim in shark infested waters, you are uncertain whether you will be attacked. You are exposed because you would suffer and possibly die if attacked. Being both uncertain and exposed, you face risk.
Uncertainty is not knowing what will happen. Exposure is caring about what happens.
Some people insist there is a third essential component of risk. That would be
Let me explain.
If you are uncertain about some consequential event, the set of possible desirable outcomes is sometimes called your “upside risk”. The set of possible adverse outcomes is then your “downside risk”. For example, if you will either win five dollars or lose three dollars based on a die toss, your upside risk is a gain of five dollars. Your downside risk is a loss of three dollars.
Based on this distinction, people argue that, if all possible outcomes are desirable, there can be no risk. Stated another way, if there is no downside risk, there is no risk. Let’s call this the “three-component” notion of risk. It requires three components
for there to be risk.
This three-component notion does reflect common usage. We tend to reserve the word “risk” for situations of possible adversity: fires, floods, diseases, accidents, financial ruin, etc.
But the third component—downside—is superfluous because the two-component notion of risk implies it. Wherever there is a dispersion of possible material outcomes, some will be more desirable than others. On a relative basis, some outcomes will be desirable and others undesirable. In this sense, where there is exposure and uncertainty, there is necessarily downside.
Three-component proponents reject this view, claiming that relative downside is not enough. They insist that there be absolute downside. As an example, consider an Olympic athlete in a final round of competition. Based on the outcome of this round, she will either win a gold or silver medal. Three-component proponents would see no risk, since both possible outcomes are desirable. Two-component proponents would see risk because the athlete would prefer gold to silver.
The three-component notion fails because it is impossible to distinguish “absolute” downside in any consistent way.
Imagine you hold a lottery ticket that will tomorrow be worth either nothing or a $1 million. Since no outcome entails a loss, do you face no downside risk? Suppose we take into account the $10 you paid for the lottery ticket. Based on this view, You have a high probability of losing $10 and a minuscule probability of winning $999,990. Now do you face downside risk?
Suppose you were instead given the lottery ticket by your uncle. Does that make the downside risk go away?
Consider still another scenario, that you purchased the ticket with your own $10, but three months ago, your uncle gave you $10, and it could be argued that it was that $10 you spent on the lottery ticket … or maybe not. Now do you face downside risk?
Suppose a pension fund implements an investment strategy that will result in its portfolio being worth either $10 million or $100 million a year from today. Most people would agree the pension fund is taking extraordinary risk, but on what basis do we consider the $10 million outcome to be absolute downside risk? Most people would agree that, from an absolute standpoint, $10 million is something to be desired.
We could assess the pension fund’s possible outcomes in terms of dollars gained or dollars lost. This approach—assessing possible outcomes relative to one’s current state—is not absolute. It can always be used to discern certain outcomes as relatively undesirable relative to others. To cite earlier examples, the Olympic athlete would prefer her current state of having a chance to win gold to the possible future state of having won just silver. You would prefer your current state of holding a lottery ticket that may be worth $1 million to the possible future state of owning one that is worthless.
This brings us back to what I said earlier:
Wherever there is a dispersion of possible material outcomes, some will be more desirable than others. On a relative basis, some outcomes will be desirable and others undesirable. In this sense, where there is exposure and uncertainty, there is necessarily downside.
In conclusion, downside risk is relative. Where there is upside risk, there is always downside risk. They are opposite sides of the same coin. The two essential components of risk are exposure and uncertainty. Where they are present, there will be downside risk. Insisting that downside be a third necessary component of risk is superfluous and—if it makes people think there is such a thing as absolute downside risk—misleading.