Every day – from the time we get out of bed in the morning until when we get back to sleep at night – we make 35,000 decisions. Many of the decisions are made consciously, but the majority of it is made subconsciously. We make decisions about which shirt to put on in the morning, how strong we like our coffee or if we rather prefer tea. Those are the type of decisions we barely notice and that have no potential to harm us. Only when the stakes are high we put more effort in evaluating our choices.
The process of this assessment is actually what is called risk management. We do it all the time and don’t even notice it. We make it when we cross a street, drive our car, when we buy a house or decide how to spend our money. We do it 35,000 times a day.
Take the story about Thierry’s friend Dan for example. Thierry described in the previous article how his friend Dan tried to persuade him to invest into a business that later turned out to be a scam. While I hope you haven’t been in that situation before I am sure you can recount similar experiences in your life. The first step we do when faced with making a decision is to assess the consequences. There is always a favorable and unfavorable outcome. However, depending on our own values we judge the consequences differently and come to different conclusions.
The favorable consequence that Dan tried to persuade Thierry to believe was that his investment would be profitable – very profitable in fact. The unfavorable consequence however – that he probably did not focus on – was that he could lose a major share or even all of the money (that was what eventually happened).
The definition of risk
The ISO 31000 (the 2018 edition) defines risk as follows:
Risk is the effect of uncertainty on objectives.
The objective – the target, aim or purpose – is the desired outcome one ought to reach. The uncertainty attached to this objective however is the effect – or consequence – it could have.
Upside and downside risk potential
The definition of the ISO 31000:2018 (this definition was first introduced in the 2009 edition) illustrates how it is understood today that there is a upside risk (an opportunity to gain) and a downside risk (a loss). This comes as a surprise for many as risk has always been seen as something purely negative. The ISO 31000 definition now puts uncertainty in the focus and therefore attaches risk management to decision making.
How risks are measured
Risks are measured by the consequence of the risk materializing (the effect) and in likelihood of it becoming an event. The (unlikely) upside consequence of Dan’s investment was to make Thierry filthy rich, but the (more likely) downside risk was owning just some valueless coupons and losing most of the investment.
You can see now that risk and opportunity have to be compared when making a decision. If the (downside) risks would have been well within Thierry’s risk appetite in order to achieving the (upside) opportunity, then he would have made an informed decision. Even if the risk (loosing the investment) would have materialized, he would still be very comfortable with his decision. That’s the reason why we buy lottery tickets. We accept the risk that the coupon will be a blank because in view of the upside risk potential the assessment is that it’s worth the try.
Assessing the likelihood
When we reduce all the uncertainty everything that’s left has to be certainty. That being said, determining the likelihood of an event is where we usually get it all wrong. While lack of information and data is one reason for it, bias is probably at its core. We often make decisions based on past experiences (you know how the saying goes: “We always made it that way,” or “We never had any problems with that”). Unfortunately the past is not very helpful in predicting the future. That’s why it is so important to get a diverse view when making a decision.
Managing risks is preparing for possible consequences before and after you’ve made your decision. You can put measures in place so the unfavorable outcome does not become an event, or you can chose not to accept the risk at all and walk away from the situation (as Thierry did).
Managing risk actually requires a regular reassessment of the situation to see if we’re still comfortable with our decision when things have changed. This can be because outside conditions have changed (like the economy or the marketplace), but also your internal values. While outside conditions are often more apparent, internal conditions are also regularly changing. They are at the core of whats important for you and determine the risk appetite. A friend of mine just recently sold all his stock when he became a father to his first born child. While he was happy to accept downside risks during his bachelor life, becoming a dad and being responsible for his daughter actually shifted his core values entirely. He became more risk averse as he valued stability over long term gains.
Safeguard effects, or: why life insurance does not make you immortal
A tool you can use to manage your risks is to safeguard them. When the risk event cannot be ruled out or be prevented you can still mitigate the impact it has. Take an elementary risk such as a fire as an example: While measures can be put in place to prevent house fires from occurring they can never be absolutely ruled out. Fires have devastating impacts on a wide range of our life. Most importantly on the health and safety, on the infrastructure, and on the financial situation. To safeguard the financial impact insurances can compensate on that. However, the infrastructure will still be damaged or even lost and, possible immaterial values and also human life cannot be brought back . That’s why life insurance does not prevent you from dying (as the name could suggest) – it only covers the financial impact for your loved ones.
How to make informed decisions
Now you understand that risk management is actually nothing else than informed decision making. To implement a risk based approach you can start as follows:
- Have a strategy in place. Become aware of your personal values and act accordingly. Your values, vision, mission and strategy will act as a beacon when faced with uncertainty in decision making
- Become aware that you are about to make decision. Spot the important decisions out of the 35,000 you make each day – the ones that have the most impacting consequences (positive and negative) and evaluate them
- Gather information that could potentially reduce uncertainty: if someone tries to convince you with confidence but without presenting information that supports the argument then the outcome is highly uncertain. If all necessary information is available a decision can always easily be made
- Assess the likelihood of the event materializing and compare possible alternatives
- If you can’t rule it out make sure that you safeguard the most devastating consequences. Better be safe than sorry.
To support this answer the 5 questions below:
- What are the (upside and downside) consequences of my decision?
- What information do I have that reduces the level of uncertainty?
- Are there other alternatives to the decision? – if yes, go back to 1
- Are there possible mitigations I can put in place to reduce the likelihood, or to safeguard the impact (e.g. insurance)?
- In view of the (upside) opportunity, am I willing to accept the (downside) risk?
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