Monday, August 10, 2009

Managing Risk

There is a great guest post on the Freakonomics blog today about the need to manage risk.

Here is the link:

The Authors of the post (Jeremiah H. Chafkin and Andrew W. Lo) base their post on the Laurence Gonzales book Deep Survival -- the story of 4 mountain climbers who died while climbing back down Mt. Hood in Oregon after reaching the summit.

The climbers' error was in focusing on reaching the summit of the mountain -- supposedly an "easy" mountain to climb -- and not remembering the need to pay as strict attention to the way down. Lo and Chafkin take the Gonzales premise (that the climbers' mental model of this "beginners" mountain did not match the reality of that day) and point out the similarity in thinking about the economy prior to the current downturn.

In their words:
The remarkably consistent performance of the U.S. residential real-estate market over the decade from 1996 to 2006 may have had the same effect, leading many experienced businessmen to conclude that such growth was likely to continue indefinitely. And despite all the protections that were available to these captains of industry — analytics that showed large potential losses in the event of a downturn in housing prices, leverage constraints imposed by regulatory capital requirements, and warning signs from the hedge-fund industry in 2005 and 2006 — they charged ahead anyway, with the single-mindedness of a well-funded expedition hell-bent on conquering a mountain. Their mental models apparently did not match reality either.
The authors point to modern science that shows that decision-making is not always fully rational and fully informed and question the need to build professional skepticism into senior management -- a Chief Risk Officer.

It is definitely worth reading...