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
Unnecessary risk is risk one can eliminate without adversely affecting expected returns. Capital markets will not reward one for bearing risk that one can avoid.
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.