Risk of ruin

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Risk of ruin is a concept in gambling, insurance, and finance relating to the
likelihood of losing all one's investment capital or extinguishing one's bankroll
below the minimum for further play.[citation needed] 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.

Contents
1 Finance
1.1 Risk of ruin for investors
1.2 Financial trading
2 See also
3 Notes and references
4 Further reading
Finance
Risk of ruin for investors
Two leading strategies for minimising the risk of ruin are diversification and
hedging/portfolio optimization.[1] 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.)

The probability of ruin is approximately

{\displaystyle P(\mathrm {ruin} )=\left({\frac {2}{1+{\frac {\mu }{r}}}}-

1\right)^{\frac {s}{r}}}{\displaystyle P(\mathrm {ruin} )=\left({\frac {2}{1+{\frac
{\mu }{r}}}}-1\right)^{\frac {s}{r}}},
where

{\displaystyle r={\sqrt {\mu ^{2}+\sigma ^{2}}}}r={\sqrt {\mu ^{2}+\sigma ^{2}}}

for a random walk with a starting value of s, and at every iterative step, is moved
by a normal distribution having mean � and standard deviation s and failure occurs
if it reaches 0 or a negative value. For example, with a starting value of 10, at
each iteration, a Gaussian random variable having mean 0.1 and standard deviation 1
is added to the value from the previous iteration. In this formula, s is 10, s is
1, � is 0.1, and so r is the square root of 1.01, or about 1.005. The mean of the
distribution added to the previous value every time is positive, but not nearly as
large as the standard deviation, so there is a risk of it falling to negative
values before taking off indefinitely toward positive infinity. This formula
predicts a probability of failure using these parameters of about 0.1371, or a
13.71% risk of ruin. This approximation becomes more accurate when the number of
steps typically expected for ruin to occur, if it occurs, becomes larger; it is not
very accurate if the very first step could make or break it. This is because it is
an exact solution if the random variable added at each step is not a Gaussian
random variable but rather a binomial random variable with parameter n=2. However,
repeatedly adding a random variable that is not distributed by a Gaussian
distribution into a running sum in this way asymptotically becomes
indistinguishable from adding Gaussian distributed random variables, by the law of
large numbers.

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.[3] 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 (with Markov chain).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.[4][5]

See also
icon Business and economics portal
Absorbing Markov chain (used in mathematical finance to calculate risk of ruin)
Asset allocation
Fat-tailed distribution (exhibits the difficulty and unreliability of calculating
risk of ruin)
Financial risk modeling
Key risk indicators
Operational risk management
Risk management
St. Petersburg paradox (an imaginary game with no risk of ruin and positive
expected returns, yet paradoxically perceived to be of low investment value)
Value at risk
Notes and references
Taranto, Aldo; Khan, Shahjahan (2020). "Gambler's ruin problem and bi-directional
grid constrained trading and investment strategies" (PDF). Investment Management
and Financial Innovations. 17 (3). doi:10.21511/imfi.17(3).2020.05. eISSN 1812-
9358. ISSN 1810-4967 � via University of Southern Queensland-EPrints.
Though US treasuries were generally an exception, except on the very worst days
their value generally rose, as part of the "Flight to safety".
Gregoriou, Greg N.; Douglas Rouah, Fabrice (2009-03-03). "22. A Risk of Ruin
Approach for Evaluating Commodity Trading Advisors". Operational Risk Toward Basel
III: Best Practices and Issues in Modeling, Management, and Regulation. John Wiley
& Sons. p. 453. ISBN 978-0-470-39014-6.
Trading Risk: Enhanced Profitability through Risk Control Kenneth L Grant (2009)
The trading game Ryan Jones (1999)
Further reading
Dickson, David C. M. (2005). Insurance Risk And Ruin. Cambridge University Press.
ISBN 9780521846400. Retrieved April 26, 2012. ISBN 0521846404
Powers, Mark J. (2001). Starting Out in Futures Trading. McGraw-Hill. pp. 52�55.
ISBN 9780071363907. Retrieved April 26, 2012. ISBN 0071363904
Baird, Allen Jan (2001). Electronic Trading Masters: Secrets from the Pros!. John
Wiley & Sons, Inc. pp. 30�32. ISBN 9780471436676. Retrieved April 26, 2012. ISBN
0471401935
vte
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