Sure, it has been said, that it was a Chinese curse, but it could be a psychic’s parlor trick as the “curse” appears to apply to any time and to anyone. Imagine for a moment how many times in the past year that you have heard the word, unprecedented? Without running through a short list of the major events I am willing to bet that it has been more than a few times that you have heard this word in the past year. In the world of risk management solutions are based on high probability events such as running with scissors is a bad thing, lay enough of these models against the situation and apply statistical analysis and you might be able to tell that the risk of missed payments on mortgages in the US will rise in December. But those are just the risks that you are looking for, and worse even is the fact that once you believe that you have a handle on risk it is likely that you will behave in an even riskier way than before you set out to understand and predict risk. This all leads us to the big question: Does risk management as we know it create more risk by fostering a sense of control over the uncontrollable.
Taleb, Goldstein, and Spitznagel point out six mistakes that executives make in risk management in the article title “The six mistakes that Executives make in Risk Management”, which appears in the October 2009 HBR review. So what are the six mistakes?
We think we can manage by predicting the “Black Swan” events. This seems obvious right! Whenever we believe that we know better, we should know that something is around the corner that will change our minds.
We believe that studying the past will help us manage risk. This belief has been drilled into us since childhood when we are taught, that history repeats itself, but really there are certainly trends that repeat themselves, and of course, with enough stretching you could equate any non-numerical event to another. The authors of the paper, however, bring up this eye-opening lesson from the past. Until the October 19, 1987 market crash the worst decline in history on the markets had been around 10 % so why would anyone studying the past expect much worse. The reality was that the marked declined by 23 % that day, and of course, that day became the new yardstick. Therefore, measuring future risk by past events turns out to be perpetually wrong. The only thing that you can take comfort in is the ability to say that it wasn’t as bad as last time. The next take-away point is that randomness in today’s world is now more prevalent than ever before. Consider these statistics.:
- less than 0.25 % of all listed companies represent half the market capitalization
- less than 0.2 % of books account for half of the book sales
- less than 0.1 % of drugs generate half of the pharmaceutical companies’ sales
- less than 0.1 % of risky events will cause half of your losses.
We don’t listen to advice about what we should do.
We assume that risk can be measured by standard deviation.
We don’t appreciate that what’s mathematically equivalent isn’t psychologically so. If you need proof on this one just look at the number of smokers even though we know that worldwide over 5 million smokers will die this year due to smoking they still light up. Couple this with the fact that we live in the most marketed to society, where various groups constantly try to frame the numbers in a way that their product, party, point of view … comes out on top. The authors illustrated their point by conducting an experiment in which they asked participants the following question:
“You are on vacation in a foreign country and are considering flying a local airline to see a special island. Safety statistics show that on average there has been one crash every 1000 years on this airline. Would you go?”
100 % of the respondents said yes. Now the authors changed the second sentence to
“Safety statistics show on average one in 1000 flights on this airline crashed.”
70 % said yes.
We are taught that efficiency and maximizing shareholder value doesn’t tolerate redundancy.
The main point is that risk management in today’s environment is extremely difficult, more attention should be paid to the question “How do we reduce the impact of the threats we don’t understand?”