Executive Summary
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“Risk” generally implies the potential for loss (gain), an unfavorable (favorable) outcome, or danger (safety).
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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.
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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.
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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.
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There are “controllable” and “uncontrollable” risks. Managers need to identify the uncontrollable risks and make conscious decisions concerning exposure to such risks.
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“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.
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Managers should employ common sense rules of risk management for survival. Esoteric models should supplement rather than displace these rules.
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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.
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Managers will benefit from awareness of and a strategy for risk and uncertainty resolution versus capital commitment with time.
Introduction
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.
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