Risk management 101
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Risk management involves three key steps: 1) identifying potential risks, 2) assessing the likelihood and impact of those risks, and 3) taking actions to eliminate, mitigate, transfer, or accept the risks. It is important because risks are everywhere and failures to properly manage risks can lead to bad or catastrophic outcomes. However, humans are often poor at objectively assessing risks due to cognitive biases that cause us to misremember outcomes and misunderstand probabilities. Proper risk management requires accurately evaluating both the likelihood and consequences of potential risks.
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Risk management 101
- 1. Risk Management 101 What is Risk Management? Why Should You Care? What Should You be Doing?
- 2. What Is Risk? There are many, even conflicting, terms and definitions of Risk: danger possibility peril chance exposure jeopardy consequence hazard menace threat gamble OPPORTUNITY
- 3. Why Should You Care? • Everyone faces risks • Risks are everywhere • Even when recognized, risks are often poorly understood • Bad – even catastrophic – things happen when Risks are not managed!
- 5. Why Are Risks Misunderstood? • We easily succumb to selective validation—the tendency to remember only positive correlations and forget the far more numerous misses. – A common ploy used by psychics (often called the Jeanne Dixon effect) is to make dozens of predictions to increase the odds that one will hit. When one comes true, the psychic counts on us to conveniently forget the 99% that were way off. – In investing -- and gambling -- most people remember their big win, and forget the many losses that more than offset it – Potentially bad outcomes are weighted much more heavily than mildly bad ones – even when the likelihoods are very different
- 6. Personal Risk Assessment Mile-for-mile and trip-for-trip air travel is at least 1,000 times safer than driving …
- 7. Personal Risk Assessment 2 … but an air crash seems much more likely to be fatal.
- 8. Managing Risks Regardless of definitions, there are 3 agreed steps to manage risks: 1. Identify potential risks 2. Assess/measure the threat 3. Eliminate, mitigate, transfer or accept
- 9. Basic Risk Management Process Identify Risks and exposures Evaluate loss potential and probability Select & Implement Management Method
- 10. IDENTIFYING RISKS Some People are Lucky
- 11. Some People Not So Much
- 12. Poo Happens!
- 13. Assessing Risks • Few people understand either the probability of an event or the consequences • So … most people either underestimate the likelihood of improbable events … • Or they overestimate the consequences of everyday risks …
- 14. What Is The Likelihood?
- 15. What Is The Consequence?
- 16. • Humans have a poor innate grasp of probability – For example, what are the odds of two people sharing the same birthday in a room containing twenty three people? Many think it must be one in thirty or more. Surprisingly to most people, it is only one in two. – There's a 100 percent chance of an earthquake today somewhere in the world!
- 17. • Few understand the laws regarding truly large numbers. – Many people believe in the Gambler's Fallacy, thinking that if a tossed coin ends up “tails” an inordinate number of times in 100 trials, then “heads” is bound to come up more often in 100 subsequent trials to “even up” the score and return to a 50-50 distribution. – But – the odds of tossing “tails” is still 50% each time; the coin has no “memory” of what happened previously. • A widely accepted law of statistics states that with a large enough sample size, even the extremely unlikely becomes probable, and therefore any outrageous thing is bound to happen eventually – even 100 “tails” in a row!
- 18. Are You Safe? Our sense of "safe" is often distorted by media coverage (or the lack of it) and distance: – The disappearance of Natalee Holloway gained worldwide attention and caused a sharp decline in visitors to Aruba, even though it is the safest island in the Caribbean – fewer than 1 murder annually. – Your chances of being a victim of foul play are considerably greater in Las Vegas (more than 1,000 murders annually) than Aruba, yet no one is canceling their trip to Las Vegas because of safety. Health issues and terrorism grab the headlines but crime and accidents pose far greater risks for travelers. – In 2003 48 people died of SARS in Toronto and all of those deaths were connected to hospitals. But fear caused hotel occupancy rates to plummet from 87% to 13%. – 80 people died in traffic accidents in Toronto in 2003; but, once again, no one cancelled a Toronto trip for fear of dying in a traffic accident.
- 19. Road Trip Risks What we think…. The usual reality..
- 20. Some Probabilities of Mortality • Die from Heart Disease 1 in 280 • Die of Cancer 1 in 500 • Die in Car wreck 1 in 6,000 • Die by Homicide 1 in 10,000 • Die of AIDS 1 in 11,000 • Die of Tuberculosis 1 in 200,000 • Killed by lightning 1 in 1.4 million • Killed by flood or tornado 1 in 2 million • Killed in Hurricane 1 in 6 million • Die in commercial plane crash 1 in 10 million You are at least 1,000 times more likely to be killed on the way to the airport than to die during the flight
- 22. The Banks Still Haven’t Figured It Out After the “meltdown” of 2008, a reasonable person might assume that surviving banks and brokerages would institute better risk management procedures and controls. Far from it! Within the past 2 years … • UBS wrote off at least $5 Billion of losses from mortgage-related debt and derivatives after 2008 • AND was stung for another $2+ Billion by a junior trader who successfully concealed his bad trades for more than 2 years.
- 23. And Still Haven’t … • MF Global, the third largest commodity broker/dealer in the U.S., filed for bankruptcy as a result of excessive bets on Euro Zone Sovereign bonds. • $593M of customer funds were apparently illegally co-mingled with the firm’s funds and were officially “missing”. • The bankruptcy is expected to be the 8th largest in U.S. history.
- 24. What Should You be Doing? Investigate! 1. Read the fine print! 2. Identify and accurately assess the risks in critical or stressful situations. – You are about 10,000 times more likely to have your car stolen, than to win a lottery
- 25. And … Be Skeptical! 3. Get it in writing 4. If you don’t understand an investment or transaction, don’t make it until you do. 5. Insure against catastrophe.
- 26. • Failure to understand and act appropriately can be very costly! • Knowledge is protection!
- 27. Answer These Key Questions
- 28. Why Are You Doing Whatever It Is?
- 29. Are You In The Right Place?
- 30. At The Right Time?
- 31. With The Right Tools?
- 33. Or Not?
Editor's Notes
- Risks are everywhere and in every activity; some are small and easily overcome; others are big and need careful planning and attention to avoid or mitigate. Risk Management is a systematic effort to identify, assess and manage risk – whether business or personal
- Few people have an intuitive sense of the odds of an event – so most people are poor poker players. Instantly knowing the odds of losing – and the changing odds as more cards are turned up – is a requirement for professional players.
- People try to find patterns in random events, even when they should know better. The “tails” in a normal distribution really can occur; that’s the premise behind Six Sigma.
- How many of your road trips do you expect to go smoothly, vs how many end up with problems!
- Everyone has heard of someone killed by lightning – since it usually gets on the news – but everyone KNOWS someone who has been killed an a car wreck.
- Some barriers are no barrier at all to the truly determined!
- Big banks were run by the producers and traders before 2008, and they continue to be run that way now. Because – they are the ones who bring in the money! Changing that paradigm is not easy, and takes a long time even with the best intentions.
- Most Importantly – pay attention, and recognize what risks there are in the situation you find yourself in.
- When someone calls you on the phone to tell you that you just won a big prize, and all they need is your credit card and social security number to verify – do you immediately hang up? Of course, you do. Then you should also avoid opening email from strangers, no matter how tempting the offer appears. Real businesses that do not currently have a relationship with you do NOT send unsolicited email offering important benefits – and if you are on the Federal No Call list, they don’t call you either. They send you junk mail, which you can peruse without fear of compromising your identity.
- If your stockbroker is so smart, ask him if he is putting this investment in his children’s educational fund. If not, ask why not!
- Especially in making personal investment decisions, ask yourself why this one rather than something else. If you don’t know, step back and consider.
- Too often the latest “hot stock” is at the peak and ripe for a correction. The average investor buys high and sells low; it works a lot better if you do the opposite.
- Knowledge is the #1 tool you need.