Some things to think about when assessing risk

I reproduce an Observation I wrote in February 2008. I want to add to it but in order for me to make my point I need you to re-read the first one.

Some things to think about when assessing risk

First

“Risk” has two components:

          Probability (of occurrence); and

          Magnitude (of consequence).

          Examples –

… that an asteroid the size of New York City will hit the earth this summer.

… that a skunk will get squashed in the middle of the road (my favorite song) this summer.

Second

When people review a risk which has been realized they amplify their assessment of the probability of occurrence in proportion to the magnitude of the consequence. The bigger the consequence the more they amplify the probability.

          Example-

                             9/11/2001

The truth is that there is no correlation between the magnitude of consequence and the probability of occurrence.   It is very tempting to make that correlation but very wrong to do so.  One should assess each component separately.

Third

When something at risk does in fact occur, people experience a level of surprise.   The intensity of the emotional response of surprise depends largely on how unexpected the occurrence was. In large part this is dictated by the length of time since the last time the occurrence happened.  Long time big surprise, short time little or no surprise, never happened before and the surprise is a whopper. If it is a recurring event then the intensity the of the emotional reaction is directly related to the number of times a sequence occurred before the pattern was broken.

Fourth

Surprises can be negative or positive.  A negative surprise carries a lot more emotional impact than a positive surprise.

So when you have a negative event happen that has never happened before,  and the magnitude of consequence is very significant, every neuron in your brain is directed in a manner which causes you to want to conclude that the event was bound to happen when in fact it was not.

Finally

Keep those four points in mind as you assess a situation… “you don’t have to look and you don’t have to see cause you can feel it in your olfactory.”  Catchy tune that one.

          For those of you that don’t listen to country music occasionally you miss some very intellectual lyrics. “Crossin’ the highway late last night, he shoulda looked left and he shoulda looked right. He didn’t see the station wagon car; the skunk got squashed and there you are!                 -02/25//2008

Now for

Some things to think about when assessing risk (part two)

I looked at a portfolio last week for someone which clearly demonstrated the following-

Make no mistake either or both of the components of risk can have a negative consequence for you. Today the focus is on “magnitude of consequence.”  Let me give you an example. Say you build a portfolio with a bullet proof bond. For purposes of this discussion let’s call it twelve feet tall and bullet proof. The probability of occurrence (of a negative development) is, in fact, next to zero.  Now load that portfolio up with the bond – go ahead namby pamby – say 80 to 90 percent of the account.  Have you affected the probability of occurrence?* No you have not but you have affected the magnitude of consequence.  Trouble?  Can you say Lehman bonds (or structured notes)? To paraphrase another country song:  In default, in bankruptcy and (your) broken hearted.

So among other things diversification reduces risk because it lowers the magnitude of consequence. You may wish to consider this when managing your risk even when the probability of occurrence is next to ARS, I mean zero.

*     There are circumstances where concentration in a portfolio increases the probability of occurrence but I chose one example where it would not to place maximum emphasis on my point.