Flawed thinking on financial risk

Risk right.jpgHaving no risk management systems in place may be better than having the wrong systems in place. That seems to be one of the lessons from the recent financial meltdown.
The reason for this apparent paradox is that awareness of risk makes people cautious. But if they wrongly believe that all risk has been removed, then this can lead to over-confidence and potential disaster. Two recent articles highlight this issue:
• Paul Ray of ICIS kindly sent me The risks of risk management.pdf” by an expert in quantitative finance, which shows why banks failed to anticipate the credit crunch, despite employing thousands of highly qualified mathematicians to quantify risk for them.
• Prof Nassim Taleb (author of ‘The Black Swan’), calls on companies and investors to boycott banks and business schools that employ the widely-used “value at risk” methodology, which he believes is fatally flawed.
Both authors believe that managing risk is not just a financial exercise, but also requires an understanding of human nature. It is well-known, for example that an unfortunate side-effect of building safer cars is that people feel more confident, and some may drive too fast as a result. This is bad news if you happen to be a pedestrian, and the driver fails to spot you crossing the road. Unfortunately, this has been the outcome in the financial world, as a result of flawed thinking on risk.

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