“Risk” generally implies the potential for loss (gain), an unfavorable (favorable) outcome, or danger (safety).
Uncertainty is different. Many characterize “uncertainty” as the doubt as to the outcome. Uncertainty may stem from lack of knowledge about a potential outcome, or from variability in the outcome that has nothing to do with available knowledge.
People argue over the definition of risk and what kind of risk is relevant in the pricing of assets. Our approach defines risk as whatever risk influences investor behavior and the resultant pricing of assets.
An increase in the perceived risks of any asset results in a decline in its value. Most economic models view this as a nonlinear relationship.
There are “controllable” and “uncontrollable” risks. Managers need to identify the uncontrollable risks and make conscious decisions concerning exposure to such risks.
“Unnecessary risk” is risk that can be eliminated without adversely affecting expected returns. Exposing your company to unnecessary risks garners no reward and adversely affects company value.
Managers should employ common sense rules of risk management for survival. Esoteric models should supplement rather than displace these rules.
Survival in an uncertain environment with exposure to risk argues for a strategy of preserving the right of choice and commitment, and avoiding positions that force a course of action.
Managers will benefit from awareness of and a strategy for risk and uncertainty resolution versus capital commitment with time.
We are fortunate to live in a world characterized by risk and uncertainty. Absent risk and uncertainty, with work, diligence, and access to information we could know each event that was to transpire. We would lose the opportunity for expectations, dreams, surprises, good fortune, and much more. We might as well have these “good” things, since in a certain world we presumably would still have “bad” events. Conceptually, in an uncertain world we can in fact choose to avoid some risks and bad events, or at least mitigate the effects of these events.
Common sense guidelines or rules will assist in garnering the benefits of bearing risk, allow us to make decisions that make sense, and protect us from unacceptable consequences. For simplification, we will consider a risk relative to a situation—for example, a new product, surgery, oil exploration, negotiating the release of hostages—and refer to the whole as a “project.”
First, let’s look at essentials, then some common sense rules, and after that ideas for action. Surprisingly, we admit that historically people have benefited—and in the future they will continue to benefit—from ignoring everything we say here. People have taken risks without conscious evaluation or without regard to risk–return relationships. Sometimes the results have been incredibly beneficial or rewarding. On other occasions the results have been disastrous.
People differ in their views concerning risk and uncertainty. “Risk” generally implies the potential for loss (gain), an unfavorable (favorable) outcome, or danger (safety). A number of investors would think of risk in a semivariance or asymmetric sense: It’s only risk “if it comes out bad.” More generally, one thinks of risk as an outcome that may vary (favorably or unfavorably) as a result of the underlying process(es) that will generate the outcome. With respect to investments, many define risk as the chance of variability in the outcome.
Some characterize “uncertainty” as the doubt concerning the outcome. Uncertainty may stem from lack of knowledge about a potential outcome, or from variability in the outcome that has nothing to do with available knowledge.
An “outcome” that occurs at a point in time may result from chance, the influence of variables (for example a force), or a combination of both. Often the risk of a venture may have its origin in one or more factors. In a dynamic rather than a purely mechanistic environment, the inherent risk of an investment may vary with time. Alterations in the origins of risk result from changes in the array or level of influence of variables that affect outcomes.
One can sometimes limit risk by influencing or even eliminating the influence of certain variables on outcomes. Generally, these efforts have costs that will affect the net outcome of circumstance.
For ease of discussion, we will combine risk and uncertainty in a practical way: With risk and uncertainty, we don’t know for sure what will happen. Additionally, we will define “risk resolution” as the emergence of reality, the resultant impact on the variables that influence the outcome, and the event and the consequences that occur.
Core principle: We do not live probabilities or expected values, or predicted or modeled outcomes. We live the events of reality that arrive with time.
The demise of Long Term Capital Management (LTCM) in 1998, creating global financial panic, tells us that even the legends of Wall Street and the incredible talents of Nobel laureates cannot alter this principle. Shirreff (2004) illuminates a host of issues related to LTCM and other aspects of risk. The subprime debacle, as well as certain derivatives, shows that some continue to ignore fundamental principles, or harvest returns while foisting the risk and consequences of poor decisions on others. These and other historical events prompt us to share perspectives and common sense rules on risk.
Common Sense Rules
Since we live events, not distributions or probabilities, applying some common sense rules will enable us first to survive, and second, to survive on favorable terms.
Identify All Sources of Risk1
Turn over every rock to unearth factors that may influence the outcome of the contemplated course of action. Sources of risk fall into major categories:
Inherent in the project: For example, the ability to complete a project as anticipated, the outcome of events related to pursuit of the project, whether the oil is there or not, and technical issues.
External to the project: For example, political and market factors that will influence the realization of the project and/or the benefits it brings. External factors may influence whether the project proceeds as planned (denied permits, blocked access, nonavailability of materials) and/or the realization of expected benefits even if the project itself is brought to completion as expected (changes in energy prices or taxation, expropriation, etc.).
External–inherent effects: Forces external to the project may affect the course of the project or its outcome. A rise in the cost of ingredients used in a food processing/marketing venture with consequent effects on markets and margins is an example.
Inherent–external effects: For example, the outcome of a project may alter the external environment, as when a project changes the efficiency and economics of microchip manufacturing, with a major impact on applications and markets.
Never Bear Risk Unintentionally
Under the right circumstances the conscious bearing of risk offers opportunity. Having a source of risk that “surprises” us offers the prospect of various outcomes ranging from good, through unfavorable, to bad—perhaps uncontrollably bad or even disastrous.
Remember that risk allows the possibility of good as well as bad outcomes. An outcome that stems from the unconscious bearing of risk might offer an incredibly good reward. Recognizing the possibility of good/bad outcomes is quite different from doing well accidentally. Unfortunately, danger lurks in bearing risk unconsciously—we do not get to choose if the outcome is good or bad. Absent an awareness of the risk, unless we have succeeded in getting another party to bear all known and unknown risks, the impact of unfavorable consequences falls on us.
Overlooking or inadvertently ignoring certain risks can have a disastrous impact on outcomes. A recent disclosure suggests that a major manufacturer of aircraft may have failed to consider consciously the risks attendant on signing sales contracts denominated in one currency while having significant exposure on the input and production side in another currency. Importantly, the choice to accept such risk is logical and defensible even if the subsequent chain of events proves unattractive. To overlook risk when making decisions differs considerably from the choice to accept a risk.
Choose, Rather than Be Compelled, to Bear Risk
Historically, the decision to assume risk, coupled with the events that transpired, has resulted in some very beneficial outcomes. In risk exposure, the issue is choice rather than the level of risk. We purposely offer an example from outside economics. In 1928, a daring surgeon and a patient—the true equity in the venture—took a huge risk when the surgeon performed the first hemispherectomy on a human.2 Individuals have taken extraordinary risks in many fields and under many circumstances so that others might benefit, and we later accord them accolades or see them as an intrepid explorer or hero.
Consciously deciding to bear a risk if there is sufficient potential benefit is logical. Inadvertently bearing risk due to a lack of diligence fails the test of judgment.
Returning to the arena of business, recognizing and accepting the risk inherent in exposure to multiple currencies differs considerably from discovering later that one failed to consider the risks and potential consequences of bearing this risk.
Only Take On Risk You Can Afford to Bear
Regardless of the expected return, bear risk only if the consequences of an adverse outcome are tolerable.
Common sense argues that we avoid risks with potential outcomes that to us are unacceptable given circumstances. Consciously accepting the risk of bankruptcy and ruin to oneself is acceptable. Indeed, a personal choice “to pursue the dream” in the face of huge risk has played an important role in the world, and it will always do so. To lose your own mind capital, or financial or physical capital, or even your life by electing exposure to certain risks seems defensible—and the world has benefited from such risk-takers.
In contrast, exposing others to a risk who cannot tolerate that risk or its potentially catastrophic outcome fails the test of common sense. More importantly, exposing others to risk they do not knowingly choose to bear fails the test of decency and morality.
Clearly Understand Who Is Bearing Risk
Knowledge of the origins and nature of the elements of risk is essential to follow this rule. Whatever the risk at a point in time for a particular project, someone is bearing the risk—either singly or divided in some fashion amongst more than one party. To illustrate, a company may feel it should not bear the collective risks of several projects during a particular time window or during certain phases of the projects. Consequently, the company may share this risk with other parties, with this shedding of the risks either permanent or transitory.
Protect Against the Reversion of Risk
If you intend to transfer risk to another party, ensure that the transfer in fact occurs. Second, protect yourself against the possibility that the risk will revert to you without your permission, or if it does, without compensation. In addition, you must assess that the party accepting the risk can tolerate/survive the risk, and also not escape the risk in a manner that transfers it back to you.3
The burdens of responsibility extend beyond legality. If the risk effectively reverts back to you and you accept the consequences because of your sense of social responsibility, or moral stance, or to protect your reputation, then we commend you. Rather than become the risk-bearer of last resort, instead carefully transfer the risk to those that can and will bear the risk. After all, a default on the bearing of risk defeats the objective of transferring the risk.4
For various reasons, a plan for risk management across time, or during the progression of events, might include the shifting of certain risks among/between parties at different points in time or with respect to particular events and outcomes. For instance, a company may choose to avoid certain risk factors during the construction of a new facility by resorting to a turnkey contract. Naturally, confidence that the party accepting the risk can comply and deliver is of paramount importance to avoid risk reversion.
Evaluate Risk Resolution with Events and/or Time
The outcome of one or more events associated with the progress of a project can have a profound effect on the level of the resolution of risk and the remaining risk for the rest of the project path. The successful synthesizing of a substance at the laboratory level and repeated replication of the synthesis can greatly alter the remaining risk in the project. Subsequent success in attaining the expected output and quality from a pilot plant would resolve more risk and cause a drop in the residual risk of the project.
Figure 1 depicts the general notion of risk resolution with events/time, without discussion of alternative scenarios and details. However, we share an example of a core issue: the commitment of capital at risk versus the resolution of risk. This example illustrates the shifting of a major risk-reduction event to an earlier point in time to resolve a major portion of uncertainty before committing the next chunk of capital. The initial risk resolution curve is shown in the figure.
As you might expect, shifting the resolution curve to the left, as indicated by the gray arrows, often entails additional costs. The analysis and decision to pursue this path should capture the relationship between those incremental costs, the chance of an unfavorable outcome, the investment schedule, and the cost of failure.
Other approaches to coping with the pattern of investment versus time versus risk resolution exist that are important if it is impossible, or prohibitively expensive, to shift the resolution curve. For example, one party desiring to participate in the venture might find it possible to take or create an option that allows it to participate if later on risk is resolved in a favorable manner. For example, a pharmaceutical company might take an option on another small company in the situation represented by the initial resolution curve, the relative bargaining positions obviously influencing the nature and terms of the option.
Divide Return and Risk Disproportionately
In many models of valuation, changes in cash returns have a linear effect on value. Changes in the required rate of return have a nonlinear effect on value. Table 1 illustrates these relationships with a present value problem. A to B to C involve changes in cash flow, with the same dollar effect on value—up or down $24.72 as the cash flows increase or decrease from the base value–highlighted with solid line boxes.
The discount rate reflects the risk of cash flows. D, E, and F illustrate the asymmetric effects of changes in the discount rate, with different dollar effects on value. An equal increase or decrease of 1% in the rate yields an unequal change in value ($22.56 vs. $20.50).
Know the Way Out
The best analysis will not overcome the reality that we don’t know what the future holds. Even if we choose a course of action that passes all the common sense tests, we still should always ask: How do I get out of here if…?
We hope we will not have to escape a particular circumstance. Giving some thought to that possibility will prepare us for such an undesirable outcome—even though we may take an entirely different path from those identified in this process. People are remarkably resilient and creative. Thinking through things ahead of time somehow prepares the mind to work at its best, no matter what happens.
The Common Sense Test
A final step in the analysis of a decision to be taken is the power of an important question: Does the contemplated course of action make sense? Step back from the details of analysis, and from any obsession with the project, and weigh it up from the perspective of an independent observer.
Capital at Risk
Give attention the nature of the capital at risk: financial or tangible capital—or, more importantly, human capital. Care and diligence in exposing human capital to risk are critical, for example in pharmaceutical trials or new methods of treatment. Creatively determine how to minimize human capital at risk until events/time resolve risk in a manner that assures attractive expected benefits/risks for individual human capital at risk.
Avoid Unnecessary Risk
Normally unnecessary risk, if present, resides on the operating side of a company. For example, in a manufacturing setting we intend that specific events with specific outcomes should occur. That unintended events or outcomes occur often arises from poor management, poor design, or choice of inappropriate technology, process design, and so on.
Making It Happen
Applying the common sense rules for risk suggests the following:
Assess the origins of risk that may influence the potential course of action. Classify those risks as controllable, partially controllable, or uncontrollable.
Focus first on the uncontrollable elements of risk. If these factors potentially have such dire consequences as to make the outcome unacceptable, the decision is relatively simple: Get someone else to bear this risk, or abandon this course of action. Make sure that the party accepting the risk is fully able to take it on, as you don’t want it to revert to you.
Identify the potential expected benefits of taking on the risk. Segregate these benefits into two categories: those that are easy to quantify, and those that are hard to quantify.
With the expected benefits identified, for controllable risks decide if you wish to bear, hedge, or transfer the risks. For partially controllable risks, evaluate whether you can afford exposure to the residual risks.
The quantum effect. If you feel you have a course of action that offers the possibility of disproportionate returns—a quantum leap in terms of good effects or outcome—but you cannot rationalize the action in a risk–return context, then ignore everything I’ve said. Accept that you are moving from logic to feelings and commitment—and do it anyway.
Reflect and decide if the contemplated course of action makes sense.
Follow the common sense rules offered here.
We will enjoy or endure the events that actually occur in the future—not probabilities, distributions, or expected values. Common sense rules of risk management will protect one from many adverse consequences. Ignoring these rules, and making poor judgments, may yield disastrous outcomes, as illustrated only too well by the current debacle in subprime mortgages.
Models, derivatives, financial engineering, and any array of esoteric methods or practices do not overcome the fundamental fact that we live in an uncertain world. What others do will deprive us of choice, but we ourselves can increase the uncertainty of outcomes by our own behavior and the choices we make. Great care should therefore be taken to follow the common sense rules of risk management.
1 Groth (1992) offers practical details on identifying and classifying risk factors.
2 The date of the first hemispherectomy on a human as well its classification as success or failure is a matter of debate, fed by issues such as the extent of the procedure as well as measures of success. The first human hemispherectomy, in 1923, is attributed to Walter Dandy, but the first complete procedure, also by Dandy, was performed in 1933. The procedure is primarily used to treat epilepsy.
3 A social conscience dictates that one not knowingly transfer risk to a third party that, because it cannot bear or tolerate the adverse outcome of the risk, or through intent, defaults and transfers the adverse outcome to society.
4 As the reader is well aware, some parties may “accept” risk for compensation with the intent of defaulting on the bearing of the risk and garnering (stealing) unearned returns, i.e. taking the returns without actually bearing the risk.