Risk of ruin (Ofer Abarbanel online library)

Risk of ruin is a concept in gambling, insurance, and finance relating to the likelihood of losing all one’s investment capital[1] or extinguishing one’s bankroll below the minimum for further play. For instance, if someone bets all their money on a simple coin toss, the risk of ruin is 50%. In a multiple-bet scenario, risk of ruin accumulates with the number of bets: each repeated play increases the risk, and persistent play ultimately yields the stochastic certainty of gambler’s ruin.

Finance

Risk of ruin for investors

Two leading strategies for minimising the risk of ruin are diversification and hedging. An investor who pursues diversification will try to own a broad range of assets – they might own a mix of shares, bonds, real estate and liquid assets like cash and gold. The portfolios of bonds and shares might themselves be split over different markets – for example a highly diverse investor might like to own shares on the LSE, the NYSE and various other bourses. So even if there is a major crash affecting the shares on any one exchange, only a part of the investors holdings should suffer losses. Protecting from risk of ruin by diversification became more challenging after the financial crisis of 2007–2010 – at various periods during the crises, until it was stabilised in mid-2009, there were periods when asset classes correlated in all global regions. For example, there were times when stocks and bonds [2] fell at once – normally when stocks fall in value, bonds will rise, and vice versa. Other strategies for minimising risk of ruin include carefully controlling the use of leverage and exposure to assets that have unlimited loss when things go wrong (e.g., Some financial products that involve short selling can deliver high returns, but if the market goes against the trade, the investor can lose significantly more than the price they paid to buy the product.)

Financial trading

The term “risk of ruin” is sometimes used in a narrow technical sense by financial traders to refer to the risk of losses reducing a trading account below minimum requirements to make further trades. Random walk assumptions permit precise calculation of the risk of ruin for a given number of trades. For example, assume one has $1000 available in an account that one can afford to draw down before the broker will start issuing margin calls. Also, assume each trade can either win or lose, with a 50% chance of a loss, capped at $200. Then for four trades or less, the risk of ruin is zero. For five trades, the risk of ruin is about 3% since all five trades would have to fail for the account to be ruined. For additional trades, the accumulated risk of ruin slowly increases. Calculations of risk become much more complex under a realistic variety of conditions. To see a set of formulae to cover simple related scenarios, see Gambler’s ruin. Opinions among traders about the importance of the “risk of ruin” calculations are mixed; some[who?] advise that for practical purposes it is a close to worthless statistic, while others[who?] say it is of the utmost importance for an active trader to be aware of it.[3][4]

References

  1. ^“Risk of Ruin (Forex Glossary)”. Financial Trading Journal. Retrieved April 26, 2012.
  2. ^Though US treasuries were generally an exception, except on the very worst days their value generally rose, as part of the “Flight to safety”.
  3. ^Trading Risk: Enhanced Profitability through Risk Control Kenneth L Grant (2009)
  4. ^The trading game Ryan Jones (1999)

Ofer Abarbanel online library

Ofer Abarbanel online library

Ofer Abarbanel online library