Like the MotoGP rider pushing the limits on the edge, success or failure depends on judging risk accurately. There are vital things the risk-aware businesses need to understand and do. This is the first blog post in a series of four about risk management that aim to shed light on these issues.
The history of risk – a brief recap
Managing risks in business goes back far in time. There are signs that term contracts existed in India as long ago as 2000 BC. When mankind began to treat risks in a more structured and mathematical way, it was a revolutionary idea in world history. Up to that time, the future was regarded as whimsicalities of the gods, or a world controlled only by oracles.
During the Renaissance more serious studies evolved and people started to challenge the traditional ideas. In the aftermath of the Renaissance epoch, more precisely in year 1654, the gambler Chevalier de Méré challenged the French mathematician and writer Blaise Pascal to solve a puzzle that had perplexed mathematicians during two hundred years. This led to the theory of probability. For the first time one could now predict the future by means of numbers.
In 1730, Abraham de Moivre put forward the notion of normal distribution, also known as the bell curve, and discovered the concept of standard deviation. Two important ingredients of modern techniques for quantifying risk. The Law of Large Numbers was invented as well as statistical sampling.
All this paved the way for gambling, economic growth, improved life quality and technological progress. Risk management has helped our ability to make decisions in a rational manner.
What is actually risk?
Everyone knows intuitively what risk means and it does not really require an explanation. However, when working with risk management at a professional level it’s useful to have some deeper understanding about what it is and what it isn’t.
- Risks are unplanned events or conditions that may have a positive or negative effect. That is, you can risk to win money in a lottery!
- Risk is a consequence of an event with a probability between 0 and 1. Probability, likelihood and chance are related but with different meaning. Luck is a favorable outcome of a chance event.
- Risk is a measure of a deviation from an expected result.
- The difference between risk and uncertainty is that risk is measurable, but uncertainty can only be determined in terms of conditions. Risk can also be a consequence of action taken despite of uncertainty.
- Another related term to risk and probability is randomness, which is the lack of predictability in events that does not follow an understandable pattern. Separate randomised events are unpredictable, but the frequency of different outcomes over a large number of events can be predicted.
Risks are everywhere
How can we possibly survive all kinds of risks surrounding us that in worst case could ruin our life and existence at any time? Evidently and fortunately it has not turned out so bad for the vast majority, because we have been trained to deal with risks rationally. From the first day we were born, we have learned – by trial and error – to avoid hostile or uncomfortable situations that have caused us pain or anxiety. But, that is not true for everyone. Some people are indeed attracted to hazards giving them a mental boost and there are heroic risk takers as for example firefighters. The word risk derives from the Italian riskare which means ‘to dare’!
So, in daily life, in general, we manage risks pretty well, both consciously and unconsciously. When it comes to the professional life we need to add one component, which is some kind of risk management methodology or structure.
Risk Management starts by the identification of possible risks. One big problem is that some serious risks are ignored when being regarded as unimportant.
Risk management should be a continuous process where you: (1) identify risks, (2) assess and evaluate them, (3) plan and organise, (4) implement risk-mitigating measures. The be-all and end-all to make it successful lies in effective communication. Risk management is NOT an undertaking for the maverick or the isolated department.
The goal of risk management is to reduce risks to an acceptable level and weight benefits against costs. The overall risk strategy needs to be reflected in all individual ventures.
The risk of overconfidence in models
A risk in itself will occur if you put to too much confidence in risk models. Models are just models and can be very misleading not representing the real world.
Bearing in mind the financial crisis 2007, there were few risk models, if any, that fully could foresee the devastating effects that followed. However, there were some hedge managers who were right in there predictions and could make enormous profits speculating in the housing bubble. One of them is the hedge fund legend John Paulson who made a spectacular bet against the subprime mortgages and earned almost 4$ billion! Statistically, there will always be those that is right in the timing and assumptions, but it doesn't automatically mean that they know what is going on. Regarding John Paulson, he obviously knew what he was doing and had done the homework as he managed to earn an even bigger amount of money a couple of years later.
Developing and using tailored risk models for one’s own purposes is a good means to better understand the risk environment and be able to perform calculated risk activities. The opposite would mean rashness or doing nothing, which is a really bad risk strategy.
To be continued.