Friday, December 6, 2013

There's More to Risk than Just Risk

Risk is a four-letter word. There is even a book with that title (I've never read it and I'm neither recommending it nor panning it). Every CFO will tell you that they hate risk. Most large companies in today's world have large departments whose sole function is to deal with risk. They are tasked with identifying risk, measuring risk, and mitigating risk.

So, John, you're telling me there is more?

I'm afraid there is. When you have fairly constant risk, you can develop a plan to measure it and often to control it. On the other hand, when your risk is volatile, that feels worse.

Consider a hypothetical element of risk related to some sort of performance. Let's say that the mean performance is denoted by 0 and that good performance is denoted by a positive number and poor performance is denoted by a negative number.

Which series of outcomes would you rather have?

  • 1, -1, 1, -1, 1, -1, 1, -1, 1, -1
  • 0, 7, -4, -8, 6, -3, -11, 5, 8, 0
I suspect that 100% of my readers like the first scenario better. Why? Each has mean and thus expected cumulative outcome 0. But, in the first scenario, the expected downside is (negative) 0.5. In the second scenario, it's (negative) 6.5. 

I developed those results by determining the probability (based on each data set separately) of achieving a sub-par performance and multiplying that by the average negative score in all years in which the score was negative. 

Suppose I want to insure or hedge against this risk. In the first case, it seems like I would be safe insuring against a risk of 1. Suppose I can afford to actually lose (and cover out of assets) 0.5, then I need to purchase insurance or a hedge to cover the other 0.5 each year. 

In the second case, however, it's not so easy. If I know that my loss could be 11, does that mean that I need to insure or hedge 10.5? At the very least, I need to be able to cover my expected downside (for years in which I have sub-par performance. So, in no event can I consider hedging or insuring less than 6.0. 

While the relationship may not be linear, it is probably not a bad approximation. So, in this case, depending upon my view of the situation, I need to insure or hedge somewhere between 13 (this possibly is a linear model and is 6.5/0.5) times as much and 21 (costs less than 21 times as much and developed as 10.5/0.5) times as much. 

That additional cost and it is likely very significant in this case is the cost of volatility. And, that's just the financial cost. There is also the headache cost, the reputational cost, and lots of other associated costs. 

So, when somebody tells you that some riskier strategy is better because it has more upside potential, look at it the other way. Nobody ever lost sleep over an upside. 

Think about it a different way. Consider yourself a golfer. On the 18th green, you have a 5 foot putt that affects a bet you have made. If you are a millionaire and the bet is for $1, you probably don't care all that much (other than for ego and pride) whether you make it or not. You can afford to lose or not win $1. On the other hand, suppose you have $50 to your name and the putt is for $5,000. If you're like most people I know, you will be petrified. You can't stand that kind of risk.

Business works the same way.

Think about it.

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