Risk

What is Risk, Really? Risk is a concept that we encounter in our daily lives, yet it can be surprisingly complex to define. In simple terms, risk is the possibility of something bad happening. But when you delve deeper, this definition becomes much richer and more nuanced.

Imagine you’re about to cross a busy street. You might think, ‘What if I get hit by a car?’ That’s a straightforward example of risk. However, in business or finance, risk can be far more intricate. It involves uncertainty about the effects or implications of an activity with respect to human values.

Definitions Galore

Many definitions have been proposed over time. For instance:

• The effect of uncertainty on objectives (International Organization for Standardization)
• Exposure to loss or injury (Oxford English Dictionary)
• A chance or situation involving a possibility of something bad happening (Cambridge Advanced Learner’s Dictionary)

Each definition offers a unique perspective on what risk entails. Some definitions focus on the statistical likelihood and magnitude, while others emphasize human interaction with uncertainty.

The Evolution of Risk Definitions

In insurance, for example, risk involves situations with unknown outcomes but known probability distributions. This is quite different from how risk is perceived in finance or project management. In finance, volatility of return is often equated to risk, while in project management, risk is seen as an uncertain event that affects project objectives.

From Markovitz to Modern Times

The equivalence between risk and variance of return was first identified by Harry Markowitz in his seminal work ‘Portfolio Selection’ (1952). This laid the foundation for modern portfolio theory. Later, Wald (1939) used statistically expected loss as a definition of risk, which is now known as decision theory.

Definitions have evolved over time to better capture different aspects of risk. Kaplan & Garrick (1981) proposed likelihood and severity of events, while the Association for Project Management (1997) adopted the concept of uncertain events affecting objectives.

Risk in Practice

Business risks are controlled using techniques of risk management, including intuitive steps, regulations, and insurance. Economics is concerned with the production, distribution, and consumption of goods and services, where risk often refers to quantifiable uncertainty about gains and losses.

Environmental risk assessment aims to assess the effects of stressors on the local environment, while financial risk includes market risk, credit risk, liquidity risk, and operational risk. Financial risk management uses measures such as variance or standard deviation to determine aggregate risk in a portfolio.

Risk Perception

Understanding how people perceive risk is crucial. Risk perception involves intuitive understanding of uncertainty and concern about harmful events. Heuristic principles like the availability heuristic can lead to systematic biases, while cultural theory views risk as a collective phenomenon influenced by factors like dread and unknown risks.

The Role of Emotions

Emotions play a significant role in evaluating risk and making decisions. The affect heuristic proposes that judgements about risks are guided by the positive and negative feelings associated with them. Fear, anxiety, and dread can significantly impact perceived risk levels.

Research has shown that people often adjust their behavior based on perceived risk levels, becoming more careful when they sense greater risk and less careful if they feel more protected. This is why understanding both logical and emotional factors in risk assessment is essential.

Risk Management

The field of risk management involves a systematic approach to managing risks. It consists of several key steps:

• Communicating and consulting
• Establishing scope, context, and criteria
• Risk assessment (identification, analysis, evaluation)
• Risk treatment (selecting options for addressing risk)
• Monitoring and reviewing
• Recording and reporting

Risk assessment can be qualitative, semi-quantitative, or quantitative. It involves recognizing and characterizing risks, evaluating their significance to support decision-making.

The Tolerability of Risk Framework

This framework divides risks into three bands:

• Unacceptable risks – only permitted in exceptional circumstances
• Tolerable risks – to be kept as low as reasonably practicable (ALARP)
• Broadly acceptable risks – not normally requiring further reduction

The risk function is defined as the expected value of a given loss function, considering the decision rule used in the face of uncertainty. Volatility measures the degree of variation of trading prices over time, while beta coefficient measures an individual asset’s volatility to overall market changes.

Conclusion

Risk management is not just about avoiding bad outcomes; it’s also about understanding and embracing potential opportunities. By recognizing the subjective nature of risk definitions and the complex interplay between logical and emotional factors, organizations can make more informed decisions that balance safety with innovation. After all, isn’t life itself a series of calculated risks?