Risk Is A Balance Between Emotion and Deduction

"...instinctual reactions are quick and automatic, usually in times when the facts are not known for there is not enough time to process what little is known. Analytical reasoning is much slower and much harder, if we relied on analysis alone, decisions about risk would paralyse us..In every day life, the mind juggles the two methods of risk assessment..Instinctual bias can alter how people gauge the odds in making a wide variety of presumably rational decisions, from investing money to preparing for disasters. For example, most people would appreciate that a chance of infection of one in 100 million is near zero. But if a friend says he knows an infected person, then our instinctive risk assessment system is more likely to focus on the numerator then on the denominator. Am I the one in 100 million?...... the system often flips from one extreme to another, from ignoring risk altogether and then over reacting..."

Benedict Carey, 2014

An interesting example of challenges with risk is banking. Traditional banking business model makes failure easy, ie the models essential features are

- maturity mismatch

- opaque assets with far more downside than upside

- markets capable of unpredictable volatility

- leverage exposure

"...human beings cope with future perils by making mental models of the past and searching the present for clues..." that fit the known past

Harrison Young, 2015

Banks manage risk the same way. Risk means knowíng odds and handling outcomes, ie uncertainty. Banks infer the odds then act as though they were certain, which usually works. Sometimes it doesn't, thus banks need capital and liquidity buffers to handle recessions, rate shocks and other remote but plausible contingencies. Rare events are difficult to model as there can be limited data, unexpected correlations and non-linear events. Need to have a flexible approach to make adjustments to your average positions. On the other hand, building the appropriate buffers based on market feedback has its downsides as you may react too late to make the changes based on feedback. To handle this, the concept of "new means risky" is used. For example, rapid growth can mean acquiring new customers, new markets, new products, new systems, etc. Each of these new activities has potential extra risks that need evaluating.

The Minsky phenomena - as time passes since the last crisis, risk aversion leaks out of the system!!!!! Immediately after a crisis, we have a tendency to overestimate risk and move slowly and carefully; but over time this changes, ie we become more confident and less risk-averse. In fact, good fortune can dull people's sensitivity to risk. What has been described by Keynes as "animal spirits" returns, ie people become less frightened, less cautious, less worried about risk, more adventurous, innovative, aggressive, more opportunistic, etc.

For bankers the cycle is

"...As you bask in the sunshine of past success, increase position limits, make larger loans to weaker credits at fatter spreads, grow faster, offer new services, enter unfamiliar markets, trim capital and liquidity buffers, undertake more information technology upgrades and get less sleep, and at some point, losing control becomes easier. By the time the bank reaches its perceived-risk boundary it will have gone way past the boundary that matters..."

Harrison Young, 2015

In other words, every state of equilibrium contains the seeds of its own destruction, eg a boom becomes a bust. In sectors like banking that have large impacts on the economy and broader community, there is a need to adopt the "minimax strategy" which demands a margin-of-safety approach, ie play it safe by seeking to minimise the maximum loss that could occur like carrying an umbrella on a sunny day - this is most important if you only have one set of clothes and are going to an important meeting!!

The margin of safety means that the caller halts activities before reaching the perceived risk boundary or limit. Thus successful bankers should not aim to be profit maximisers as survival periodically requires them to forego perceived marvellous opportunities

For example, study the below matrix

                                     Strategy A                            Strategy B

Prospect                    90% chance of 50                95% chance of 100

                                 10% chance of -200             5% chance of -1,000

Expected value                    25                                        45

Under the strategy B, the probability of a positive outcome is higher and bad outcome is lower; with the expected value of strategy much higher than under strategy A. On the other hand, the impact of externalities could result in outcomes under strategy B being horrendous. Using the minimax approach, strategy B is safer while strategy A could be described as the economically rational choice.

Need to understand the fundamental opacity of risk and the necessity of financial conservatism. It is very hard to measure the risk one is taking. Even though we can build models that tell us the probability distribution of outcomes, it is very hard, if not impossible, to forecast how risks will interact in a chain reaction among multi-businesses. Banks use an ad hoc mixture of qualitative analysis and common sense to try to understand the risk involved. Using stress tests, scenario planning can help explore hidden linkages and transmission mechanisms. At best, they are a vehicle for discussion to help pool experience and refine judgement, ie collective gut instinct. But this can be dangerous in unfamiliar, uncharted territory. Risk can involve actual and perceptual; the latter is an amalgam of raw data, model output and gut feeling, ie the pattern of the past and current clues. We can identify the level of perceived risk we do not want to exceed.

To help handle risk you need to diversify and have a range of opinions involved in the discussions so that people are bringing different perspectives to bear.

"...deciding when to be cautious and when to be bold calls for nitty-gritty understanding of cash flows and markets and relevant political dynamics, but also hinges on remembering the perils of the new and the distorted perceptions that flow from a run of good luck. Selling early is a test of character..."

Harrison Young, 2015

One of the Rothschilds was once asked how they had become so wealthy. The answer was "selling too soon"


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