Risk management has caused many people to substitute one four-letter word for another. They will use the word RISK when they should be saying LOSS. And there is a world of difference between the two. It is the difference between the gleam in eye of the loving newlyweds and the cry of the babe in the middle of the night. (Really dating myself there. That is one from a 1950′s movie.)
A RISK is a potential for a LOSS. The LOSS is the realization of that negative potential. A RISK is running across a busy street blindfolded. A LOSS is getting hit by a car while doing that.
All RISKs do not result in LOSSes and all LOSSes do not result from RISKs.
A RISK is putting a revolver with one bullet up to your head and pulling the trigger. A LOSS is the result of the chamber with the bullet being fired. A RISK without LOSS is when you pull the trigger and the hammer hits an empty chamber. A LOSS without RISK would be putting a revolver full of bullets up to your head and pulling the trigger.
When You Exceed Your Risk Limit
So if someone asks you what you intend to do when your RISK limit is exceeded, you have choices. One of those choices is to ignore the potential breach and hope that you are fortunate. Those who make that decision and do not find that RISK turning into a LOSS will go down as RISK geniuses. Those who find themselves facing a LOSS that is larger than they can bear will be thought to be dunces.
Other choices involve the many ways that one can use to reduce the frequency or severity of the RISK, to bring it within your limit. But even if you do take those choices, your reduced RISK may still result in a LOSS. If your evaluation of the RISK was correct, then the reduced RISK may help to limit a LOSS that exceeds your limit. But if your estimate of the RISK was incorrect and you have a LOSS, then the LOSS may be larger than your limit, even if you carefully followed procedures to reduce the RISK.
When Your Loss Exceeds Your Limit
But if someone asks you what you intend to do when a LOSS exceeds your limit, that is an entirely different story. The choices there are few. The LOSS has happened. You should then
- Learn to live with the consequences of the LOSS that you were trying to avoid by setting the limit, and
- Try to learn the cause of the loss that exceeds your limit and discern whether you can make changes that will help you to avoid such situations in the future.
Living with the Consequences
Learning to live with the consequences of the LOSS may well mean adjusting your risk limits to the lower risk buffers that you may now have access to.
The opposite of learning to live with the consequences is the destructive but common practice of “doubling down.” When a gambler “doubles down” after a loss they are hoping to make back their losses with their next bet.
Traders are sometimes prone to this thinking. They conclude that such behavior is the only way to save their job after a large loss. Often such actions lead to the opposite consequence for the trader.
Learning from the Loss
Learning from the LOSS means tracking down whether the excess LOSS resulted from excess RISK-taking, RISK measurement error or results from a predictable but highly unlikely event.
The excess RISK-taking can be from failure to follow procedures including the failure sited above to act once a breach of limit is found.
Other failures can be seen from Jared Diamond’s excellent analysis of failure. Diamond, the author of the bestseller Guns Germs and Steel, suggests that civilizations have failed because of four types of failures:
- Failure to anticipate a problem before it arrives
- Failure to see a problem once it arrives
- Failure to even try to solve a problem once they have perceived it
- Failure to solve a problem that they are trying to solve
Confusing Risk for Loss
However, when answering these questions, be aware that sometimes folks have started to use the word RISK when they should be using the word LOSS. One person recently was talking about their risk management program and went so far as to say “realization of the negative potential of a risk” when they meant LOSS.
In risk management programs, when asked for a RISK tolerance, the only thing that folks can think of is often a LOSS tolerance. That can work in some situations. But in many cases, the certainty that is usually implied by a LOSS tolerance is much too expensive.
- No LOSSes above $10 million is a LOSS tolerance statement
- No situations where the likelihood of a LOSS over $10 million exceeds 95% is a RISK tolerance statement
RISK management techniques are meant to apply to identify and affect tendencies. In his book “Stress Test: Reflections on Financial Crises,” Timothy Gethier quotes Robert Rubin as saying “you can’t judge a decision by how it turns out, only whether it made sense given the information available at the time.” And that is another aspect of what it means to focus on LOSS instead of RISK.
When you focus on LOSS, you are making a determination based on the after-the-fact situation. A decision that made perfect sense at the time it was made can look much worse when you find out that it had an adverse outcome (what I mean is a LOSS).
But if you can religiously focus your RISK management program on making the best decisions with the information available at the time, the future will look different than the past. That is because the past has LOSSes, the future only has RISKs.
This post was originally published July 30, 2014.