“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.
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