The Art and Science of Risk Management: Introduction

Hello my fellow Steemians

I’ve joined this community in the hope of educating you about risk and how to better manage it in business and in life.

My knowledge of the subject is quite good – “stick to what you’re good at” as they say. I have Postgraduate degrees in Statistics and Financial Mathematics (these are useful tools - although risk management is both an art and a science). I can’t say I’m a veteran – I have only 5 years of work experience – I am fortunate though to be heading the risk unit of a major investment holding company with investments in healthcare, agriculture, textiles, finance and hospitality. So, as you can imagine, I have a big weight on my shoulders and yet still have much to learn. So please don’t hesitate to share some of your ideas with me. At the very least, this community will help me with my communication and writing skills.

This post marks the first of what I hope will be many. Yes, I am feeling motivated for this new venture into little-known waters. Yes, its full Steem ahead!

Let us begin with our first lesson: What is risk and what is risk management?

There are many definitions of risk and you can find them just by surfing the web. From my point of view, the best definition of risk out there is provided by the International Organization for Standardization (ISO) 31000, a family of standards relating to risk management. It states that risk is “the effect of uncertainty on objectives”, where “effect” implies a change or deviation from what we expect.

Objectives may refer to anything from grocery shopping to building an empire. When it comes to grocery shopping, we generally expect to smoothly achieve this objective. When it comes to building an empire we generally do not expect to achieve this objective. But that does not tell us which one has the highest risk, even though it might appear obvious. You might say: “I do not expect to achieve my objective, but what the hell, I’ll take risk”. If you are certain that you will not achieve your objective then there may be little risk involved. The risk is not in your expectation of loss, the risk relates to the uncertainty surrounding your expectation. The less certain you are about your expectation, the higher the risk.

"Risk comes from not knowing what you're doing" - Warren Buffett

For example, let’s say achievement of your objective is binary i.e. either you achieve it or you don’t. Your risk is highest when your expectation to achieve that objective is 50/50 (for those stats-minded people out there, you may take comfort in this example by looking at the standard deviation of a Bernoulli random variable). Take another example regarding investments, if you expect an investment to have a negative return, that doesn’t not mean the risk is higher than one that has a positive expected return. The risk refers to the volatility of the return (more of this in another post). You might say: “well, what if we don’t know what to expect?”. People don’t generally set out to achieve an objective with zero inclination of what to expect. You might argue that some people will get on a plane and travel to the middle of nowhere for that very reason. They may say: “I have no idea what to expect but I’m just going to get on that plane anyway, for the sake of spontaneity, for the sake of living dangerously!” Well, guess what, you do in fact expect to enjoy yourself, or at least survive, else you wouldn’t get on that plane. You may think gambling at the casino is 50/50, but casinos can only make money by skewing the probabilities slightly against you. That’s why, when it comes to gambling, unless the game requires skill, you should always expect to lose. There are special cases, like the flip of a fair coin, whereby there cannot be any expectation - only the deviation of expectation exists. Its either heads or tails and the only way to eliminate the risk is by not flipping the coin. Looking at it another way though, we could argue that an expectation of zero is still an expectation…

We all have objectives in business and in life. We all have a set of expectations in achieving our objectives. Along the way, things can unexpectedly turn for the worse (or for the better – risk includes the upside too!). Preparing for these unexpected turns is what we call risk management. If you think about it, we are already managing risks day-to-day.

Say you’re late for a party and you find out at the last minute that its quite a way away, how high above the speed limit will you drive to avoid FOMO? Your objective is to get to the party in good time. Your expectation could be that you will achieve your objective at 10mph above the speed of limit give or take. This would not be a calculated measure of course; it’s more of a gut feel i.e. call it your natural speed limit on the road. It is at that speed you feel comfortable enough to drive and at that speed you expect to keep a good eye on speed traps. This natural limit, which may change depending on your level of FOMO, is what we refer to as risk appetite (more on that in another post). In this scenario, although the risks are obvious, you would only be partially prepared for them by way of your driving experience, your knowledge of the roads, car insurance, etc. However, not all of you would call a friend at the party to find out exactly where the speed traps are, if there are any accidents, or potholes, etc. On the other hand, not many of you would consider that a speed limit is set for a reason.

You may still live dangerously if that’s your appetite, but as a risk manager I must advise you to consider the full picture first. We must combine our natural ability to manage risk, our instincts, with a structured and comprehensive method of thinking - balancing art and science. You might be surprised by how much value it will bring to your business and life. I therefore encourage you to think about your objectives. What are your expectations? Have you set them correctly? What are the risks? Which ones will you accept, which ones will you try to avoid or mitigate? How will you control them? Are there potential upsides over and above your expectations? How will you capitalize on these upsides?

Next up – more on the importance of risk management,
Your risk connoisseur,
J-MLN