The Behavioral Risk Manager

There are usually two images of a risk manager that make their way through Hollywood and the popular consciousness.  The first is of a nagging scaredy-cat, basically a coward, who stands in the way of the bold and the beautiful as the world is conquered.  This person is usually presented as if they are in risk management because they could not stomach the uncertainty of getting the job done.   Often this person is a nerd.  The second image, more current, is that of the math geek.  During the financial crises these folks were either presented as smart and right (but ignored) or too smart and wrong (and blamed).

I would like to present a third image of the risk manager.  This person is as much of a psychologist as a mathematician.  At the root of all risk is a human value system, and it is this value system rather than stock price volatility or inclement weather that drives risk-taking.  If all risk stems from a value system, it follows that fundamental to an understanding of risk is an understanding of human psychology.  It is for this reason that I use the term behavioral risk manager as pioneered by firms like Oxford Risk and Upside Risk.

The term behavioral is a reference to the field of Behavioral Economics.  Throughout its history, traditional economics has assumed a “rational actor” as fundamental to its theories.  No one was claiming that everyone was completely rational, but it was generally useful to assume that “in aggregate” people would behave “as if” they were rational.  This had the benefit of allowing economists to develop models of social behavior that could be quite useful.  One prime example of a model based on this premise is the Efficient Market Theory which states that markets will reflect the fair value of an asset if a few requirements are met.

While many of the theories of traditional economics are very useful, sometimes it seems lacking in its ability to describe with world around us.  No one expects it to have the kind of precision that Physics has, but it does seem as if it should be able to do better.

In 1979, Amos Tversky and Daniel Kahneman published their work on Prospect Theory which marked a real breakthrough on the attempt to present a model for humanity other than a rational actor.  In their work, they outline a variety of human biases that caused systematically-irrational behavior.  It is key that the irrationality is systematic because the “as if” rational actor theory essentially assumes that the irrational behavior was random and would be canceled out in aggregate.  Systematic irrationality can be modeled, expected, and anticipated.  It does not cancel out in the aggregate.

I propose that traditional risk management, and the traditional risk manager, have faced a challenge similar the traditional economist.  On some level, there seemed to be the belief that people took imprudent risks because they did not understand the risks that they were taking.  In this view, people were rational but misinformed or ignorant.  If only these bold decision makers could take the time to understand their situation better, then all imprudent risk-taking would vanish from the globe.

The behavioral risk manager does not see the world this way because human psychology does not manifest itself in this manner.   Whereas the traditional risk manager sees laziness as a cause of poor risk analysis, the behavioral risk manager recognizes that cognitive energy is a scarce resource.  The rational side of the human mind lives on a strict budget.  You cannot spend here without taking from there.  Whereas the traditional risk manager sees risk-averse people who misunderstand a situation, the behavioral risk manager see situations where people are known to be risk seeking.

There is no doubt that people are generally poor appraisers of uncertainty. Understanding the psychological mechanisms that kick into gear when faced with uncertainty is crucial to tackling risk, and to be clear, risk is just uncertainty.  Risk is not necessarily bad.  Uncertainty is the source of opportunity.  One of the PR problems faced by traditional risk managers is their continual focus on “threats” or “downside” risk.  Perhaps they can be forgiven because in many cases this is their job.  The other half of risk management is “opportunities” or “upside-risk.”  In many organizations what has been done is to divide the risk manager’s job into two.  Risk managers handle the threats and regular managers handle the opportunities.

When you think about this, it is bizarre.  Image a baseball manager sending two players up to bat simultaneously.  They are told to share the batter’s box.  One is instructed to try to get a hit, and the other is instructed to prevent strike outs.  First of all, should the hitter actually get a hit, there is much glory–much more glory than if you just prevent a strikeout which is, let’s face it, quite dull.  What would happens eventually is that the two batters end up hitting each other–both striking out to the amusement of the fans.  In some sense this is how risk management is embedded into many organizations today.  It is an add-on that just seems to get in the way of businesses as they seek to hit the big home run. Ironically, in baseball, the Oakland A’s success against the odds depended on them focusing on players with high on base percentages (i.e. they walked a lot, i.e. they avoided striking out).  These players were often undervalued and the A’s could afford them because they didn’t actually hit the ball as much as other players even though they got on base more.

This is not to say that external, independent review and oversight is bad.  It is essential.  However, by focusing only on threats and failing to help a business exploit opportunities, traditional risk managers make themselves at best irrelevant and exiled to the basement and at worst a huge pain (which is really no fun for anyone).  In both scenarios, they are fundamentally ineffective.

Indeed, the behavioral risk manager is not really a risk manager at all.  She is a line manager with responsibilities who mitigates threats and exploits opportunities.  She understands prevalent human biases, and she implements practical, low effort, systems to minimize their impact.  She exploits mathematics, particularly statistics whenever possible because she recognizes that her eyes and ears can be fooled.  In Moneyball, Michael Lewis quotes Bill James in a discussion about evaluating baseball hitters with your eyes.

The difference between a .300 hitter and a .275 hitter  is one hit every two weeks….  If a fan saw both hitters for 15 games during a year, there is a 40% chance that the .275 hitter would have more hits than the .300 hitter . . .  The difference between a good hitter and an average hitter is simply not visible–it is a matter of record.

He continues..

We notice what the hitter does.  If he hits a smash down the third base line and the third baseman makes a diving stop and throws the runner out, then we notice and applaud the third baseman.  But until the smash is hit, who is watching the third baseman?  If he anticipates, if he adjusts for the hitter and moves over just two steps, then the same smash is a routine backhand stop–and nobody applauds.

The behavioral risk manager recognizes this conundrum.  One key to her success is an organizational culture that values solid quantifiable process, innovation, and consistency over anecdotal success.  It is a culture that embraces uncertainty for its opportunity, assess calculated expectations, and keeps very good records of outcomes so that true performance can be accurately judged over the long term.

 

ASP.NET Core and Aurelia

I have been diving into new web development technologies.  For too many years to mention I have been working with Microsoft ASP.NET technologies.  Recently, I have started working with a variety of new ones, including:

  • Ruby on Rails
  • ASP.NET Core
  • Aurelia
  • Node.js
  • and the variety of associated helpers (Gulp, Bower, etc.)

It has been a great change for me, and really opened my eyes which had admittedly been a bit cloudy due to too many years working on the same stack.

What prompted me to write this post was what I was able to do this evening.  I recently bought a new MacBook Pro to work on a Ruby on Rails project.  (Also, my Lenovo laptop was over three years old.  It still runs well, but my kids keep dropping it, so it was a bit shaky.)  This evening, I opened up Visual Studio 2015 on a Windows machine running inside Parallels on my mac.  I create a new ASP.NET Core project, and committed it to Github.  I then cloned the repository on my mac, and open the project in VS Code and ran it.  So for most people the fact  that I was could browse a ASP.NET website on the same computer, at the same time on both Window and iOS is not that remarkable.  For me, it was really a statement for how far we have come with software development.  Furthermore, most of the code used to run the website was open-source and maintained by independent groups of people.  It is really a great time to be a web developer.

This lead me to my next adventure–Aurelia.  I have been messing around with Aurelia for about a week now, and so far I really like it.  It seems to be a nice clean middle ground between react.js and Angular.js.  I am looking forward to launching some open-source initiative using it in the coming months, so stay tuned.

On Volatility, Risk and Popping the Cork

There is a debate in the wine industry about the cork.  Traditional, romantic and symbolic, popping the cork has long signaled the start of a celebration.  The problem with the cork is that it is not that good at what its primary task—sealing a bottle of wine.  Modern screw caps are far superior in this regard, yet the cork endures.  Why?

The cork endures because its secondary task—providing a pleasurable and ritualistic moment—is just as important as its ability to seal a bottle.  People enjoy uncorking a bottle of wine the same way they enjoy putting on a vinyl record or working in a garden.  In the cork, we have one tool that fulfills two needs—the desire to experience ritual (at which it is great) and the need to seal a bottle (at which it is OK).  The cork’s versatility results in its survival.

In the financial world, volatility tries plays a similar role.  The cork combines two roles into one, and so does the concept of volatility as risk.  There are two types of investing risk:  fundamental risk and liquidity risk.  Fundamental risk is the uncertainty in the the economics of an investment.  Will Apple meet its earnings targets?  Will GM default on its bonds?  The second type of risk is liquidity risk.  Will I be forced to sell my Apple shares due to a need for cash?  Volatility is one measure that has traditionally  encapsulated these two vastly different types of risk.

However, while we can forgive the romantics for their love of the ritual of opening a bottle, we cannot forgive financial theorists for intermingling two distinct types of risks into one measure.  Volatility is and will always be a misleading and potentially damaging measure of risk.  Not only does it lead investors to ask all the wrong questions, it encourages them to value all the wrong information.  They look at historical price fluctuations rather than current financial statements.  They look at head and shoulder patterns rather than their own cash flow.  Sadly, this is encouraged because it has been easy.  Solid tools have been lacking to ground the investor in the economics of a business—tools that help and investor separate fact from speculation.

At Prudena, we have recently launched two tools to help investor.  The first is an Implied Growth Rate Calculator which does a back of the envelop calculation on how much speculative growth is priced into a stock.  The second is a Margin of Safety Calculator which looks at the financial statements of a company and earnings estimates to do a rough calculation on the rate of financial return for a stock given an investor’s required return.  Neither of these tools is intended to provide answers.  Rather, they are intended to equip and investor to challenge the market price.  Taken together, the tools are a starting point for fundamental risk management.

So, the next time you are at a cocktail party and someone starts talking to you about volatility as risk—and some fancy formulas to exploit this—lookNext page› down at your glass of wine.  Remember the cork and how it can serve a dual role.  But also remember that evan though volatility as risk is a tradition, it is no cork.  It is not strong enough to play the dual role that it has been given.  Smile, have another sip, and remember that rollercoasters are safer than cars if you don’t have to get off in the middle of the ride.