Wednesday, 29 April 2009

What Risk Is and Is Not

 I attended a short sharp “training session” about credit risk the other day. It started with an invitation for us attendees to names some risky activities. Crossing the road, bungee jumping, eating raw oysters, lending money... everything, it seems, carries some risk. I call nonsense. Here are a number of things risk is not: it's not the probability of something bad happening; it's not the loss you will incur if the event happens; it's not the expected loss of the event either. 

You can apply the word 'risk' to these things (you can apply any word you like), and in the mathematical treatment we do, but real life isn't mathematics and you lose understanding of the world you live in if you do so apply it.

Bad debt is not a risk: it's a fact of business life. It becomes a risk if one of your customers going bad can take your company down. If you jump in front of an express train, you are not taking a risk, you are attempting suicide. Crossing the road is not a risk – unless it's the A40 in the rush hour when you are not taking a risk, you're just being stupid or foolhardy.

Banks routinely lend money to people with a limited ability to repay it: at the lower end of the credit scale, banks may lose up to thirty per cent (or more) of the money they lend to people in that group. Defaulting isn't a risk – it's a certainty that they will lose that money. They just don't know who will default.

This is the first point about risk: it has to be something that might not happen in some sensible period – usually a month or a year. If it's going to happen, like defaulting on loans, it's not a risk: it's a certainty. The risk the banks are running is that one year, the world will stop being average and hit them with an extreme they can't handle. Then they are broke. This is part of Taleb's argument about black swans.

Downsides don't create risk. Drive your car, you use petrol and that costs money. That's not a risk, it's an expense. Bet on the horses and you will come out with less money (after paying the entrance fee, parking, food and a couple of Coca-Colas): that's not a risk, it's the price of admission. Twisting on fifteen at blackjack isn't a risk: it's a gamble. If you have just bet the school fees on the next card, that's not a risk, it's morally culpable, grounds for divorce and time you called Gamblers Anonymous.

Some surgical procedures can seem pretty extreme, but given you were going to die if they didn't get going, are they really “risky”? You're dead anyway – these guys are giving you a chance you didn't otherwise have. (The real downside isn't that they don't save you, it's that they don't save you enough and you spend the rest of your life being a burden on your relatives, the taxpayer and yourself.)

Going into a village that's a known insurgency stronghold is a risk for the soldiers – they might lose their lives, or worse, lose limbs or senses – but it's not a risk for the Army – it has plenty more soldiers. For that matter, going into that village is a much greater risk for you, the civilian reporter, than it is for the soldiers, who have been trained to do that stuff. At least the Medivac is there if anything goes wrong.

What makes a downside nasty is that you cannot recover from it without huge expense, expertise you don't have or even at all. If you can recover from it, even if doing so means the usual three-hour wait in A&E or a few months of frugal living, then it's not a risk: it's One Of Those Things.

So this is what's risky: an event that might not happen with a downside from which you do not have the resources to recover with everything pretty much intact.

Safety is not the absence of all risk. We are “safe from”, never just “safe”, though sometimes the qualification may be implicit in the context. A battered husband may be safe from his bullying wife in the refuge, but not from redundancy at work.

Safety is the having all the usual downsides covered. Children in a playground will trip and scrape keens and hands. They're perfectly safe as long as the school has some iodine and a plaster. Since Mummy doesn't carry iodine, the children may be safer at school than they are with Mummy.

The more competent at the game of life you are, the fewer risks you face and the safer you are. The less competent, the more hazardous the world you live in.