Risk and uncertainty

What does “take more risk” mean?

Last week I picked up on something from a Norman Marks blog post. But something also caught my attention in the comments below it, which has intrigued me before: the idea that organisations might want to “take more risk”.

The idea that we might be taking “too little risk”, and therefore should “seek to take more risk” is something that comes up when people talk about risk appetite. But what does “take more risk” mean?

This might sound like an silly question. After all, if we consider crossing the road (which is an over-used analogy when organisational risk people introduce the topic of risk management) then what it means to take more risk is pretty clear. It means something like crossing the road with our eyes closed, or allowing ourselves less time between speeding vehicles—things which allow us to achieve largely the same result but with a greater chance of catastrophic consequences.

But this analogy doesn’t translate to the corporate world, because there we really do want to be successful. The equivalent of crossing the road without looking—which might be, say, embarking on a project without any kind of plan—would be unthinkable. And even if we imagined a less extreme example, then simply increasing the chance of a negative outcome would be irresponsible. It’s fair to say that organisations’ success criteria do not include increasing the chance of failure.

To answer the question I turned to my old friend the probability curve, which is a genuinely useful way to think about uncertainty, instead of binary success/failure risk events. The curves below aren’t definitive, but they will help.

Consider a curve which signifies our current state, and which we declare to be a situation with “too little risk”. The x-axis shows the degree of our success (positive) or failure (negative).

We want to “take more risk”, whatever that means, so let’s imagine some ways we might shift this curve following some action, and see whether that might constitute taking more risk.

First we might shift it to the right…

Now everything is much better—we have a much better chance of a successful outcome. But we couldn’t reasonably describe this is taking more risk.

We might shift it to the left…

This has the opposite effect. Everything is general worse, and while we could fairly describe this as taking more risk, it isn’t something any organisation would reasonbly want to do. So this isn’t what we mean by “taking more risk”, either, because we wouldn’t want it.

Third, let’s squash the curve in and up…

Now we’re reducing both potential losses and potential gains. If we aren’t happy with the potential losses of the original situation then this might be considered an improvement. However, we still couldn’t really describe it as taking more risk because we’ve reduced our potential losses.

Finally, let’s squash the curve down and out…

Now we’re increasing both potential losses and potential gains. We could say we are increasing our risk, but we’re also increasing our chance of gains, which means this is arguably a desirable situation. So this is the most reasonable depiction of what we might mean.

The distinguishing feature of each of our plausibly desirable changes above is either increasing our upsides, or decreasing our downsides, or both. Merely increasing our downsides is not desirable, which to me means that talking about “too little risk” and “seeking more risk” are misleading phrases. “Seeking more risk” is most likely to mean that we seek a more positive outcome, but are prepared to accept a greater chance of a negative outcome if that’s necessary. It’s a two-way deal.

 

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Discussion

2 thoughts on “What does “take more risk” mean?

  1. Thanks for referencing my post.

    So, let’s say that you are walking down the street. It’s not a very busy street, but there are cars passing by.

    You spot your spouse on the other side of the road. He waves for you to join him.

    But, you signal that its too dangerous to cross right away and that you are going to the next set of traffic lights to cross.

    Then, he falls and collapses, clutching at his mid-section. Nobody is there to help him.

    Are you now more willing to take the risk of crossing the street?

    How about if your investment policy has traditionally required you to invest only in gilt-edged securities. You auditor points out that while you are risk averse here, you are entering into hundreds of millions of dollars of derivatives contracts.

    Should you amend the investment policy to take more risk?

    Posted by Norman Marks | 24 October 2017, 10:50 pm
  2. Thank you for the comment, Norman.

    My post above is really just trying to say that the phrase “seek more risk” is rather misleading, at least to me, and possibly to others who are not specialists. After thinking through it with diagrams I understand it means “higher chance of a downside to achieve a higher chance of an upside”, rather than just “higher chance of a downside” which might be an intuitive meaning. In other words, it consists of two sides, the downside and the upside.

    Your comment covers scenarios I didn’t cover. My example simply said “this is the situation”. Your scenarios say “you thought this was the situation, but in fact it’s different”. In both your scenarios we change our actions (possibly allowing a more negative outcome) because we want a more positive outcome. So again, we’re not seeking more negativity without also seeking to improve the positive.

    I think we’re agreeing on that. Your scenarios show that (surprise!) risk an uncertainty is much more complicated than can be captured in blanket phrases; more detailed pictures are much, much more helpful.

    Posted by Nik | 25 October 2017, 9:43 am