Passive Risk

Passive risk refers to the risk that arises from inaction in business operations or any field, potentially leading to losses. It indicates the absence of proactive risk management actions, increasing the probability of risk exposures.

Passive choices indicate a lack of enthusiasm in choosing plans, and it can lead to passive risk. When individuals or entities make passive choices, such as neglecting proactive risk management or failing to take action to mitigate potential risks, they increase their exposure to passive risk. Hence, passive choices can lead to increased vulnerability to risks and missed opportunities for growth or improvement.

• Passive risk refers to the risk associated with not taking proactive action in a business to prevent potential risks from materializing.
• Passive choices usually lead to passive risks.
• It highlights the importance of active risk management and discourages taxpayers from relying solely on passive investments to protect their income.
• Passive risk acceptance and retention are common elements in project management, indicating that businesses may accept risk without modifying their plans, potentially leading to long-term harm due to negligence or inertia.

Passive risk is defined as a risk happening when one foregoes an opportunity to decrease outcome variance. Passive risk factors are important for investors who may unknowingly bear such risks due to their investment choices or lack of active risk management. Such persons do not engage in the strategic process of decision-making actively. However, they still have to bear the losses resulting from investments dependent on specific benchmarks or indexes. 

It is vital to use passive risk avoidance strategies based on the prescribed risk management approach to avoid specific risks. It is mostly studied using the concept of passive risk-taking, which is a new and evolving field. They have been underestimated as they do not have clarity and visible cues. They have a perceptual nature, meaning they do not trigger the same level of concern or awareness as active risks. 

Many researchers have concluded that people generally overlook features or indicators as risk indicators. Hence, such cognitive oversight often leads to centering on occurrences and not on non-occurrence of risks. Hence, investors need to develop a heightened personal responsibility to encompass the negatives of inactive risks; otherwise, it may lead to losses. Moreover, its usability is vital in financial decision-making as investors perceive inactive risk as less dangerous than active risk.

Passive acceptance indicates the inability to plan for the risk occurrence. The entities may accept the identified risks. If the risk is too small, the cost of a risk management plan will be higher than the cost of dealing with the risk without any preparation. 

Passive retention describes the unknown retention of certain levels of risks. Such risks subsequently lead to losses. This happens due to inadequate effort in identifying their vulnerabilities to potential losses and the absence of a corresponding plan to finance the risk. 

Let us use a few examples to understand the topic.

Example #1

Imagine a city called Old York, situated at a moderate seismic zone facing inactive risk. However, it does not care to take proactive measures to enhance building codes, emergency services, and urban planning. Hence, it faces the inactive risk of earthquakes, which leaves it susceptible and vulnerable to enormous destruction caused by it. Furthermore, it does not undertake any initiative to fortify infrastructure and enforce strict construction standards to minimize the damage caused by earthquakes. 

As time passes, the city faces increased inactive risk without a mitigation strategy and preparedness to tackle the earthquake. As a result, resident is left to the mercy of their safety tool, which is insufficient and may cause huge losses of property and lives. Therefore, the mayor and city council of Old York City must proactively address the concerns using comprehensive planning, stringent building codes, disaster management teams, and earthquake-absorbing building plans to reduce the risk related to moderate seismic activity in Old York.

Example #2

The passive risk taken by Vanguard Group stems from its focus on passive investment strategies involving index funds and exchange-traded funds (ETFs). For instance, it can expose investors to the performance of market indices and associated risks such as tracking error and market volatility. While Vanguard aims to minimize tracking errors, it remains a potential risk for investors in its passive funds. Additionally, these funds are susceptible to market fluctuations and downturns. Moreover, The rise of passive investing has sparked concerns about investors becoming too passive, potentially influencing corporate decision-making by limiting active shareholder engagement and oversight which subsequently affect the long-term financial performance of firms.

Both are separate approaches to investment management, with their differences depicted in the table below:

This article has been a guide to what is Passive Risk. Here, we explain its acceptance, retention, differences with active risk, and examples. You may also find some useful articles here –

• Risk Parity
• Active Risk
• Risk Budgeting