Understanding Risk in Companies and Our Lives

Understanding Risk in Companies and Our Lives


by Massimo Marinacci, Dept. of Decision Sciences
Translated by Jenna Walker

Risk is the water in which investors usually swim. Their job is to make decisions, to choose one action over another. To do this, they must carefully weigh all the options: they can be more or less good at it, but this is exactly what the game is.
In September 2008, the financial firm Lehman Brothers went bankrupt, setting off the serious financial crisis that affected the whole world in the following months, destroying large amounts of capital and many jobs and turning a risky situation into one of uncertainty. In fact, investors suddenly found themselves with no idea of what was going to happen. It was impossible to weigh the probability of each of the possible scenarios and choices had to be made based on very little. What's worse is that no one even knew what the possible scenarios were: the future had turned into an imponderable specter of unforeseen contingencies. The problem was no longer dear old risk: investors were now faced with an unusual and disturbing uncertainty.
Their reaction was essentially to freeze trade. Paralysis is the typical response people and markets have to uncertainty: it is the result of reasonable prudence in the face of an unknown and incomprehensible situation. As often happens, however, this reaction made things even worse.
The bankruptcy of Lehman Brothers reveals some of the fundamental characteristics of uncertainty. When a situation is uncertain, it is difficult to discern which future scenarios are most likely. In some cases it is even difficult to imagine which scenarios are possible and which are pure fantasy. This state of things often translates into the inability to make decisions or take action.
Many of the events that occur today have these same characteristics, because uncertainty is now everywhere (often evoked with the generic term "risk," which includes what we indicate here with risk and uncertainty). Climate change, for example, is the most important form of environmental uncertainty. Humanity has always been exposed to the risk of abnormal, if not catastrophic, meteorological events: shepherds have to face the risk of drought, farmers face the risk of floods, sailors face the risk of storms and generals face the risk of snow. Each of these people has expectations about the likelihood of such events happening, and for this reason uses the clues they have available to decide whether to run the risk or take precautions to protect themselves. Imagine, for example, an area of the world where shepherds know from experience that a period of drought occurs more or less every ten years. They don't know if it will hit next year or in five years. But based on these expectations, they can estimate how many provisions to set aside to be prepared, or they can create an emergency garden when signs show that a drought is about to occur.
However, in the presence of climate change, things go very differently. The shepherds' problem is no longer about when the drought will occur. Now their problem is that the expectations and clues they have always trusted no longer work. There could be five years of drought, or their once green region could forever turn into a desert. According to the Intergovernmental Panel on Climate Change (IPCC), over the next century, the global temperature could increase between a few tenths of a degree and five degrees (in the best and worst scenarios, respectively). The possible trajectories of global warming between these two extremes translate into different local scenarios in the region of our shepherds. What is the most likely? For shepherds it is difficult to guess. It depends on uncontrollable agents who influence the climate all over the world: states, companies, communities, individuals, etc.
From the examples given above, it could be deduced that uncertainty is a misfortune that produces only bewilderment and paralysis. But there is always another angle. Uncertainty rewards intelligence and entrepreneurship. Those who know how to better process the available information and those who are more inclined to take risks can benefit greatly. Talent and merit shine in conditions of uncertainty. Uncertainty is what makes life interesting and not banal. But we must never forget that it is also a source of inequality: a game with winners and losers, in which fate, more than merit, can play a decisive role (even the best players lose with bad cards).
Uncertainty is a fundamental characteristic of human society, which shapes it and differentiates it from the natural world. While the particles that compose matter passively obey natural, deterministic or probabilistic laws, the individuals and groups that make up a society are active agents: their behavior is guided by their interests and changes according to their ideas and expectations. The economy is thus different from physics. For example, in order to be effective, an economic policy action must take into consideration how people will change their consumption and saving decisions according to their interests and expectations. A reduction in income tax that causes an increase in public debt can result in an increase in savings, and not consumption, if the agents expect a possible future increase in taxes to cover the larger debt. Compulsory and coercive measures only up to a certain point, even in totalitarian systems, if they are not accompanied by incentives that align them with the interests of the agents. In short, risk and uncertainty are what make human society something special and different from the rest of the natural world.

Read more about this topic:
The Real Trouble Starts When We Think We Can Calculate Everything
Corporate Governance Is not Safe from Black Swans
A Bridge Where Decision Theory Meets Risk Analysis
Policy Makers React to Ambiguity Like Other Humans Do
No Economic System Is Safe. Shocks Travel Quickly and Unexpectedly
When International Trade Increases the Chance of Conflict
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