Risk management involves three key steps: 1) identifying potential risks, 2) assessing the likelihood and impact of those risks, and 3) taking actions to eliminate, mitigate, transfer, or accept the risks. It is important because risks are everywhere and failures to properly manage risks can lead to bad or catastrophic outcomes. However, humans are often poor at objectively assessing risks due to cognitive biases that cause us to misremember outcomes and misunderstand probabilities. Proper risk management requires accurately evaluating both the likelihood and consequences of potential risks.
2. What Is Risk?
There are many, even conflicting, terms and
definitions of Risk:
danger possibility peril
chance exposure
jeopardy consequence hazard
menace threat
gamble OPPORTUNITY
3. Why Should You Care?
โข Everyone faces risks
โข Risks are everywhere
โข Even when recognized, risks are often poorly
understood
โข Bad โ even catastrophic โ things happen when
Risks are not managed!
4.
5. Why Are Risks Misunderstood?
โข We easily succumb to selective validationโthe
tendency to remember only positive correlations and
forget the far more numerous misses.
โ A common ploy used by psychics (often called the Jeanne
Dixon effect) is to make dozens of predictions to increase
the odds that one will hit. When one comes true, the
psychic counts on us to conveniently forget the 99% that
were way off.
โ In investing -- and gambling -- most people remember
their big win, and forget the many losses that more than
offset it
โ Potentially bad outcomes are weighted much more heavily
than mildly bad ones โ even when the likelihoods are very
different
8. Managing Risks
Regardless of definitions, there are 3 agreed
steps to manage risks:
1. Identify potential risks
2. Assess/measure the threat
3. Eliminate, mitigate, transfer or accept
9. Basic Risk Management Process
Identify
Risks and
exposures
Evaluate
loss potential
and probability
Select & Implement
Management Method
13. Assessing Risks
โข Few people understand either the probability
of an event or the consequences
โข So โฆ most people either underestimate the
likelihood of improbable events โฆ
โข Or they overestimate the consequences of
everyday risks โฆ
16. โข Humans have a poor innate grasp of probability
โ For example, what are the odds of two people sharing the
same birthday in a room containing twenty three people?
Many think it must be one in thirty or more. Surprisingly to
most people, it is only one in two.
โ There's a 100 percent chance of an earthquake today
somewhere in the world!
17. โข Few understand the laws regarding truly large
numbers.
โ Many people believe in the Gambler's Fallacy, thinking
that if a tossed coin ends up โtailsโ an inordinate number
of times in 100 trials, then โheadsโ is bound to come up
more often in 100 subsequent trials to โeven upโ the score
and return to a 50-50 distribution.
โ But โ the odds of tossing โtailsโ is still 50% each time; the
coin has no โmemoryโ of what happened previously.
โข A widely accepted law of statistics states that with a
large enough sample size, even the extremely unlikely
becomes probable, and therefore any outrageous
thing is bound to happen eventually โ even 100
โtailsโ in a row!
18. Are You Safe?
Our sense of "safe" is often distorted by media coverage (or the
lack of it) and distance:
โ The disappearance of Natalee Holloway gained worldwide attention
and caused a sharp decline in visitors to Aruba, even though it is the
safest island in the Caribbean โ fewer than 1 murder annually.
โ Your chances of being a victim of foul play are considerably greater in
Las Vegas (more than 1,000 murders annually) than Aruba, yet no one
is canceling their trip to Las Vegas because of safety.
Health issues and terrorism grab the headlines but crime and
accidents pose far greater risks for travelers.
โ In 2003 48 people died of SARS in Toronto and all of those deaths were
connected to hospitals. But fear caused hotel occupancy rates to
plummet from 87% to 13%.
โ 80 people died in traffic accidents in Toronto in 2003; but, once again,
no one cancelled a Toronto trip for fear of dying in a traffic accident.
20. Some Probabilities of Mortality
โข Die from Heart Disease 1 in 280
โข Die of Cancer 1 in 500
โข Die in Car wreck 1 in 6,000
โข Die by Homicide 1 in 10,000
โข Die of AIDS 1 in 11,000
โข Die of Tuberculosis 1 in 200,000
โข Killed by lightning 1 in 1.4 million
โข Killed by flood or tornado 1 in 2 million
โข Killed in Hurricane 1 in 6 million
โข Die in commercial plane crash 1 in 10 million
You are at least 1,000 times more likely to be killed on the
way to the airport than to die during the flight
22. The Banks Still Havenโt Figured It Out
After the โmeltdownโ of 2008, a reasonable person
might assume that surviving banks and brokerages
would institute better risk management procedures
and controls. Far from it! Within the past 2 years โฆ
โข UBS wrote off at least $5 Billion of losses from
mortgage-related debt and derivatives after 2008
โข AND was stung for another $2+ Billion by a junior
trader who successfully concealed his bad trades
for more than 2 years.
23. And Still Havenโt โฆ
โข MF Global, the third largest commodity
broker/dealer in the U.S., filed for bankruptcy
as a result of excessive bets on Euro Zone
Sovereign bonds.
โข $593M of customer funds were apparently
illegally co-mingled with the firmโs funds and
were officially โmissingโ.
โข The bankruptcy is expected to be the 8th
largest in U.S. history.
24. What Should You be Doing?
Investigate!
1. Read the fine print!
2. Identify and accurately assess the risks in
critical or stressful situations.
โ You are about 10,000 times more likely to have
your car stolen, than to win a lottery
25. And โฆ
Be Skeptical!
3. Get it in writing
4. If you donโt understand an investment or
transaction, donโt make it until you do.
5. Insure against catastrophe.
26. โข Failure to understand and act appropriately
can be very costly!
โข Knowledge is protection!
Risks are everywhere and in every activity; some are small and easily overcome; others are big and need careful planning and attention to avoid or mitigate. Risk Management is a systematic effort to identify, assess and manage risk โ whether business or personal
Few people have an intuitive sense of the odds of an event โ so most people are poor poker players. Instantly knowing the odds of losing โ and the changing odds as more cards are turned up โ is a requirement for professional players.
People try to find patterns in random events, even when they should know better. The โtailsโ in a normal distribution really can occur; thatโs the premise behind Six Sigma.
How many of your road trips do you expect to go smoothly, vs how many end up with problems!
Everyone has heard of someone killed by lightning โ since it usually gets on the news โ but everyone KNOWS someone who has been killed an a car wreck.
Some barriers are no barrier at all to the truly determined!
Big banks were run by the producers and traders before 2008, and they continue to be run that way now. Because โ they are the ones who bring in the money! Changing that paradigm is not easy, and takes a long time even with the best intentions.
Most Importantly โ pay attention, and recognize what risks there are in the situation you find yourself in.
When someone calls you on the phone to tell you that you just won a big prize, and all they need is your credit card and social security number to verify โ do you immediately hang up? Of course, you do. Then you should also avoid opening email from strangers, no matter how tempting the offer appears. Real businesses that do not currently have a relationship with you do NOT send unsolicited email offering important benefits โ and if you are on the Federal No Call list, they donโt call you either. They send you junk mail, which you can peruse without fear of compromising your identity.
If your stockbroker is so smart, ask him if he is putting this investment in his childrenโs educational fund. If not, ask why not!
Especially in making personal investment decisions, ask yourself why this one rather than something else. If you donโt know, step back and consider.
Too often the latest โhot stockโ is at the peak and ripe for a correction. The average investor buys high and sells low; it works a lot better if you do the opposite.