Risk Management in Daily Life (1)

Before I venture into the use of risk management practice in a corporate environment, let's first look at how people manage risk in their daily life.

Scenario 1: Crossing a Road with No Traffic Light

Where would you cross the road? A? B? or C?

You typically make a decision based on weighing its benefits and risks.

Let's consider A. The obvious benefit is you gain at least 15 seconds compared to other options. Unfortunately the risk of being knocked over by the intimidating fire truck cannot be under-estimated, particularly the driver is sitting above ground level and concentrating on cars coming from the right. Given that the impact is quite severe as well, you must be a real risk taker if you choose A. Some people will label you as 'reckless' too.

What about C? It seems to be the safest option. The driver is at ground level. It has stopped for the traffic. On the negative side, you lose some time (perhaps less than 30 seconds). Since the traffic is moving, by the time you reach C, the car may have moved forward too, hence you may even lose more time.

A more reasonable option is B. You have a good chance of reaching point B before the road condition changes. Even if it has changed you'd still be able to cross the road since it'll take some time for a fire truck to start moving. You'd save some time too by crossing the road at B instead of C. However I think both B and C are reasonable option, depending on your appetite for risk.

A final option is to stand still and wait for the traffic to subside. You may be surprised but this could be the most time saving and life saving option, balacing all the benefits, costs, and risks.


Scneario 2: Investing in Stock Market

You have saved $50,000 and want to invest in the stock market.

The benchmark index has dropped 20% from its historical peak. 70% of the stock analysts predict it would rebound by 10% in the next 3 months.

However the remaining 30% of stock analysts forecast that the benchmark index would further fall by as much as 30% in the next 6 months.

Will you buy stocks now?

There are two things you have to consider:

(1) In risk management there is an Expected Monetary Value (EMV) concept. EMV is calculated by multiplying the probability of a risk and its impact, typically quantified in $ value or %.
Let's apply the calculation to the above scenario.
Upside EMV = 0.7x0.1 = 7%
Downside EMV = 0.3x0.3 = 9%

If we use EMV alone to make a decision, it'll be a not-invest.

(2) The second concept in risk management is even more important. What if the market suddenly fall for 30%, 40%, 50% or more? Do you have holding power? Many people lose their shirts because they need the money one month or two months later, and they have to sell at a deep loss. The same concept applies to decision that could have a severe negative consequence, no matter how unlikely it first seems. For example, if you are going to launch an initiative for your company that if it turns sour, could lead to really poor publicity, our advice is think twice. Many executives lost their jobs in the past because of exactly such actions which were deemed as 'low risk' in the first place.

Going back to our stock market decision, the more reasonable option is not to invest.

To be continued...

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