Up In Smoke

I started preparing for a cross-industry conference I’m excited to be speaking at this Spring on the topic of “Innovations in Risk Management.”  As you know, I’m a big fan of interdisciplinary applications to improve risk management, and I’ve often made analogies with the transportation (air travel) and medical industries to make my points about financial risk management.  Today, while thinking about different industries’ approach to risk management, I received the following email from the Headmaster at my eldest son’s school (names removed for anonymity):

Dear Parents,Today at around 10 am, we had a small fire at school in the boys bathroom nearest the ****** Room.  The fire occurred close to a plastic device, which emitted a significant amount of smoke, and our alarms sounded.  We evacuated promptly and determined that all of our students and employees were safe and accounted for.  The fire department responded promptly and put out the smoldering remains of the fire.

The fire department began an investigation of the fire, as did the responding police.  I do not have a report yet about the cause of the fire.  Health department representatives also arrived on the scene.  While this activity proceeded, we moved the students into ****** Gym and awaited their instructions.  Pizza was ordered for the Lower School kids, and they returned to their classrooms at around 11:30, where they had lunch.  Near noon, we received clearance to serve Middle School and Upper School lunch at the usual time in the ***** room, and then resumed classes.  We are having the affected area assessed for clean-up purposes and will move promptly to restore it to working order.

Safety is always our paramount concern, and we conduct frequent evacuation drills so we will know how to conduct ourselves in case of a fire.  That practice proved very useful today, and the students handled themselves with patience and grace.  We will continue to investigate the cause of the fire.

Best regards,

********
Head of School

 

After I realized that no one was hurt and that everything is OK, it hit me that fire drills are another excellent example of best practices in risk management.  Knowing what to do before an emergency/crisis makes all the difference, and it’s on the list of best practices produced by the Greenwich Roundtable, on which I participated.  I have to remember to thank the Head of School the next time I see him for pointing out to me the obvious example of good risk management.

This will also be a good way to start the presentation at the cross-industry conference.

No (prospect of) Pain, No (prospect of) Gain

Did you know just about every year, someone falls to their death from the Rim of the

Following the Park Ranger along the Kaibab trail.

Grand Canyon, but that no one has ever fallen off the trail while hiking into the Canyon?!  When I heard this – from the National Park Ranger who was guiding us down the one and a half mile South Kaibab Trail to Cedar Ridge in the Canyon this past summer – I couldn’t help wondering why.  The trail is somewhat narrow – about six feet wide, with a sheer drop on one side.  But the Rim has a sturdy fence or stone wall to protect all those would be Ansel Adams-es.  Why do people fall at the Rim but are OK on the trail?  The explanation I settled on last summer came up in a conversation last week on a seemingly unrelated topic: how to grow a successful business.

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Riscus

Riscus - "Difficulty to avoid in the sea."

The ancient Greeks had a word for it, ριζα, which made its way to the Latin, Riscus.  The original meaning was a metaphor for “difficulty to avoid in the sea.”  Ancient mariners traveling along the islands that dot the Mediterranean, the Aegean and the Tyrrhenian Seas knew all too well what it meant.  Over time, the word made its way to Italian – risico, rischo, and rischio; to French – risque, and to Spanish – riesgo.  Starting in the 16th century, middle-high-German adopted the term Rysigo in a business sense: “to dare, to undertake, to hope for economic success.”  This weekend, we witnessed an ironic collision of these two uses of the word: a €450M ship ran aground and ‘mostly’ sank – of all places – off the very coast where the ancients learned what ‘riscus’ is all about.

I adopted the cover of Peter Bernstein’s excellent book Against the Gods as the primary image for this blog because of this intertwined history: risk management and humanity’s attempt to conquer the seas is intricately intertwined and is rife with lessons about how to go about improving our odds of success.  It’s also a great story.

It wasn’t until the Renaissance that we started quantifying risk and making any use of mathematics to help mitigate it.  Early on, when the Ancient Greeks and Romans sailed the Tyrrhenian, they assumed that the uncertainty of survival on the seas was caused by the whims of gods like Zeus and Poseidon.  That argument – that gods cause something – has a modern counterpart: “the computer told me so.”  Both are black-box solutions to the problem that conveniently avoid the need for any real understanding.  Both employ a very unsatisfying ‘Deus ex Machina’ to overcome the problem.  Peter Bernstein made this point in Against the Gods with an analogy between the Oracle at Delphi and the modern computer: people believe the output of each because of its established authority, suggesting that trusting modern computers is as dangerous as trusting the Oracle’s advice.  I wrote to Peter objecting to this line of reasoning because modern computers have verifiable benefit, while the Oracle at Delphi was just one in a long line of superstitious beliefs that have distracted people with comfort over reality.  He didn’t budge: about as many people today, he told me in the late 1990’s, understand the output of computer risk models as back then understood that the Oracle was nonsense.  For everyone else – the severe majority of people – they are dangerously equivalent.

But such is the course of progress.  Today’s airline passengers need not understand the Bernoulli principle to take advantage of international flight.  Today’s medical patients need know nothing of molecular biology to benefit from their daily prescriptions.  Similarly, today’s investor should not need worry about Martingales or Lévy distributions to avoid catastrophic losses in their portfolios.  But we’re not quite there yet.  We’ve gotten past the belief in gods, but as I’ve said many times in this blog, we haven’t yet found the underlying dynamics that would allow us to declare a fundamental understanding of these investment waters we keep trying to sail.

The story of risk – of humanity’s struggle against the gods – is, as Pater wrote, remarkable.  The Costa Concordia accident is a vivid reminder that even with the most modern equipment and procedures, risk is very much with us, even in the same waters where the word originated.

Correlated Stresses

No, this post about “Correlated Stresses” isn’t about having both your in-laws and your weird uncle over for the holidays.  Nor is it about how your trainer at the gym has you work on abs, biceps and cardio all in the same session.  But it is about two very different ways to perform ever increasingly popular stress tests of financial portfolios.  In a nutshell, uncorrelated stresses are your worst nightmare: everything goes haywire at once.  Correlated stresses, on the other hand, only allow one thing to go haywire and then use realistic assessments of how badly every else will react.  In some sense they’re more realistic, but they may not capture enough severity.  In other words, they may not really be all that stressful.

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2012 Risk

If recent history is any guide, 2012 promises to be quite eventful.  We’re entering the new year with continuing financial turmoil across the Eurozone; the US Presidential race is starting in earnest on Tuesday January 3rd with the Iowa Republican Primary; North Korea’s new regime is promising nothing new, meaning that we can expect the same irrational and erratic behavior; we have Iranian sanctions and threats to close the Straight of Hormuz; and we seem to have a ‘new normal’ 9% unemployment in most of the developed world.  For the first time in memory, the most popular New Year’s resolution, as announced by Dick Clark’s Rockin’ New Year’s Eve, was not “lose weight” or “go to the gym more often.”  This year, or rather – last year – it was “Save Money.”  Better late than never, I suppose.

Arguing to myself that a blog about risk management should not itself engage in needlessly risky forecasting, I vetoed the very idea of presenting my predictions for risk in 2012.  So with reckless abandon that comes with New Year euphoria, here goes anyway…

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