!DOCTYPE html PUBLIC "-//W3C//DTD XHTML 1.0 Strict//EN" "http://www.w3.org/TR/xhtml1/DTD/xhtml1-strict.dtd"> Streamline Training & Documentation: What is Risk Management?

Sunday, June 22, 2008

What is Risk Management?

I don't generally buy books in hardback, but a few are too attractive to put off reading until the paperback is out. In 1996 one such was Against the Gods: The Remarkable Story of Risk, by finance expert Peter L. Bernstein, which I bought as soon as I heard about it.

In the book, Bernstein describes the centuries-long history of philosophers, mathematicians, and other thinkers gradually acquiring an accurate understanding of risk. He then goes on to discuss the principles of sensible risk management that eventually were worked out to guide decision-making under uncertainty. Midway through the book, he explains:
When we take a risk, we are betting on an outcome that will result from a decision we have made, though we do not know for certain what the outcome will be. The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us.
Finally, in bringing his book to a close, Bernstein notes:
... the science of risk management sometimes creates new risks even as it brings old risks under control. Our faith in risk management encourages us to take risks we would not otherwise take. On most counts, that is beneficial, but we must be wary of adding to the amount of risk in the system. Research reveals that seatbelts encourage drivers to drive more aggressively. Consequently, the number of accidents rises even though the seriousness of injury in any one accident declines. Derivative financial instruments designed as hedges have tempted investors to transform them into speculative vehicles with sleigh-rides for payoffs and involving risks that no corporate risk manager should contemplate. ... [links added]
Fast forward to today's New York Times. In a brief column, Bernstein applies the principles of risk management to the current debacle in our credit markets. He notes that the questions investors should have been asking as they bought houses and mortgage-backed securities were:
  • How will we deal with surprises — outcomes different from what we expect?

  • What are the consequences of being wrong in our expectations?
Bernstein reinforces the centrality of these two questions in his conclusion:
Effective risk management starts with the recognition that any forecast [e.g., a forecast about the future level of housing prices] can be wrong, then weighs the consequences of being wrong. Only then can we decide whether to make a bet, whether to hedge that bet and how to execute the hedge if needed.
The five minutes it will take you to read Bernstein's column will be time well spent.


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