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| Source:Gray Collections |
Risk Management (RM) is by far the most fascinating subject I have come across. Probably, keen study of the concept made me skeptical towards the approach we deal with it in a conventional way (or the modernistic way with Enterprise as prefix to RM aka ERM). At times, may the reading of my writing goes too technical or boring. So, please read this at your leisure and do let me know your reflections.
The best risk manager I came across or realized recently is Mother Nature; Surprised? Then, to get to know why I consider she is the best consultant in dealing with the uncertainty of life and its complexity, let’s go back to five years from now. In 2008, the world witnessed the worst recession since the Great depression of 20th century, losing out jobs in bundles, banks and reputed power houses declaring bankruptcies every other day and governments struggling to bail outs their economies. If you ask for my opinion today, whether recession did pass over, my reply may rather seem quirky as I feel the worst is yet to start. The measures taken so far are only palliative and not curative. They even administered wrong medicine by borrowing more money from China at the expense of tax payers.
The major reason for the Great fall in 2008 is not the sub-prime crises; it’s just a spark before an explosion. There are three other elements to the down fall; The Complexity of world markets and the interconnectedness of global economies, the Irrationality of investors and their panic selling during crises and the Unpredictable extreme events (aka The Black Swans)
Markets are pretty complex, they are life like and should be treated as such. But, when they are handled otherwise, by irrational beings (Investors or Traders), things get further complicated. The baffling truth about Markets is, an investor can lose all his money in a single day similar to Pareto’s law with 80 per cent of his losses coming in 10 or 12 trading days, with the rest 20 per cent accounted by all other days (on the upside – Ten most profitable extreme days in a 50 year period can represent half the returns).
Irrationality grabs me into human psychology and to “how people make judgments under uncertainty ?” I recommend reading ‘Cognitive Biases and Heuristics’ by eminent scientists Daniel Kahnemann and Amos Tversky’s who did thirty years+ research on the subject (and also got a Nobel Prize in Behavioral Economics). It is interesting to note that people make decisions not only on the basis of the risk involved, but also how the risk statement is phrased (or worded). In one of their experiments they showed, how most respondents in Risk workshops acted differently with the way Risk statements are presented to them. Quite interestingly, the two statements pretty much provide the similar sense.
Let me give you an example, given a chance of the two options given below..are you interested to buy the flight ticket from this particular airline to a beautiful and rare-visit island with the following information:
Safety statistics show that on average, there has been one crash every 1,000 years on this airline. [Risk Statement #1]
Safety statistics show that, on average, one in 1,000 flights on this airline has crashed [Risk Statement #2]
Even the mathematical outcomes are same, Risk Statement #2 has shown more emphasis.
The third and most interesting is the Unknown unknown’s of extreme events (aka The Black Swans) – like the 9/11 attack, Recent recession, Harry Potter, Android, Internet, etc. None of these products or events have been predicted before Google era (I mean, 13 years back no one would have imagined about the possible existence of these in their wildest dreams). But, today we are living with global phenomena … of universal fads, diseases, books, movies, economic meltdowns, and many more.
So, let’s connect back to Nature and find out how it’s dealing the complexity of the universe. She is highly redundant in her preparation for rainy days. Did you ever ask yourself, why a human being is gifted with two kidneys when one is enough?. One never knows what risks life would be facing in the fragile passing years of 60 plus. But in Economics, redundancy is considered inefficient and Optimum utilization is Economist’s (in)famous tagline.
In Ecology, Mother Nature never encouraged bigger species to become super big. But, 10 per cent out of the total companies (or Fortune 500 companies) hold more than 80 per cent of market capitalization. You may ask what’s the big deal in the stats given . In a complex environment, if all the elements are dependent on single source and if tomorrow the source has been lost, then it can create chaos to the entire system. Take the recent example of bankruptcies in banking industry as the closure of two to three companies stirred a tsunami in world economy. Can you imagine the death of 2-3 elephants in a savannah disturbing the entire food chain; No ! Nature had never given the scope, for an Elephant to become a Mammoth. It always kept rules that clearly define the system’s limitations. But, we never know where Mark Zukerberg’s Facebook is going to end up in its Net worth tomorrow.
All I would say in essence is that the Risk Management needs a different approach and it needs to be tested and validated with proper parallels from Nature. Many French drivers feel that they are better in driving than the majority of the French driving population. So is every entrepreneur, who is always blindly confident of his acumen in business; But, it’s the skill in concepts like Black Swans and Complexity, that gives him an edge to think or view in a probabilistic angle.
I stop here, and pass the buck.
Cheers,
Pal
