Dealing With Risks
The strength of your desire to avoid risk is likely to depend upon your economic and life circumstances, and upon the size and nature of the risky outcomes.
But to avoid larger possible losses, you are willing to pay an insurance premium that costs more than the expected value of the loss, because such a loss could disrupt your life badly.
In practical terms, we want to know which choice we should make in a particular risky situation, such as purchasing insurance or opening a law office or choosing among investment opportunities in three countries that differ greatly in political stability.
There are two steps to a sound decision:
(1) Understand the nature of the risk and how it fits into the rest of your life (your business).
(2) Use appropriate devices for allowing for the cost to you of assuming the risk or the benefit of avoiding it.
Possible Criteria for Assessing Risk
These are some of the competing principles used in risk analyses, each associated with a different criterion goal for optimization:
1. Maximization of “utility.” The utility principle is the oldest and the most widely used device to allow for risk, especially among finance specialists, perhaps because it lends itself better to mathematical analyses than do the others. It aims to maximize your “utility”—that is, the supposed satisfaction that you might achieve from the resulting sums of money. It systematically takes into account that twice as much money will not give you twice as much satisfaction, the appropriate adjustment depending upon your wealth and the extent of your dislike for risk. All this has little or nothing to do with the concept of utility that Jeremy Bentham proposed in the eighteenth century, and from which the term originally comes. When you apply this principle, you reduce somewhat the expected value of the alternative you choose in order to reduce the variability among possible outcomes.
2. Minimization of regret or disappointment or unpleasant surprise. These related principles aim at reducing the chance that you will end up feeling badly about the outcome. For example, if someone first tells you that you have won a lottery and then two minutes later tells you that it was an error, you are likely to feel worse than if you had never heard either message. (Similarly, hearing from a doctor that you do not have a disease that you thought you might have had is likely to send you out in a particularly pleasant mood.) You therefore choose in a fashion by which you reduce somewhat the expected value of your choice in order to reduce the chance that the outcome will be one that will make you feel regret, disappointment, or unpleasant surprise.
3. The mini-max principle. This principle applies to some situations that are head-to-head games with one or more other players, in which you expect them to actively try to outfox you and where your loss is their gain. This is unlike most situations in life (and in business), where your relationship with the relevant groups of individuals (such as impersonal customers) or with nature (for example, when you are drilling an oil well) is not gamelike because your “opponent” is not actively trying to outfox you. The mini-max principle is a very complicated mathematical strategy for obtaining a combination of relatively large gains while taking the chance of relatively small losses, by attempting to avoid the worst situation that your opponent might force you into. This principle may be appropriate for some very specialized games and perhaps occasionally in war. But, to my knowledge, it has never been found appropriate in everyday life, despite all the inflated claims made for it. It is a classic example of the adepts of a fancy mathematical technique succeeding in a massive snow job on people who do not understand the mathematics but are so insecure about their ignorance that they take it on faith that there must be something of value inside the mysterious mathematical black box—something worth paying a high fee for. Unfortunately, cases like this are not rare in the world of “scholarship.”
The choice among these principles for dealing with risk depends upon your taste. But if your goal is to maximize profit in business, you will not make any allowance for risk other than that warranted by market (rather than personal) considerations.
Risk in a Business Setting
Lending or investing money is a common situation in which risk is a crucial issue. When a bank lends working capital to an individual or a firm, the interest rate depends upon how risky the bank deems the loan— that is, the bank’s estimate of the chance that the borrower will default. Similarly, the bonds of firms that are unstable or have little collateral must pay higher interest rates than do bonds of firms that are more solid. The stocks of firms whose prospects are very uncertain sell at a lower price relative to the firm’s earnings than do the stocks of firms whose earnings are stable and seemingly assured from year to year. And the rate of return to preferred stocks is on average higher than the rate of return to bonds, because in case of a bankruptcy the preferred stocks would lose their value before the bonds would. (Common stocks are riskiest of all in this respect.) This structure is equivalent, from the point of view of the person supplying the funds, to a lower discount factor for a more risky situation.
The Power of Diversification
You can go beyond making a single risky choice by arranging your “portfolio” of risk-taking activities so as to reduce the total risk. For example, instead of investing all your wealth in a single stock, you can diversify among a set of stocks. A life insurance company greatly reduces its risk by selling a great many insurance policies rather than just one.
Almost any diversification reduces the overall risk even while keeping the returns the same. But it is not possible to eliminate all risk with diversification.
Summary
People pay to increase their risk when they gamble. But aside from situations where risk is exciting, people generally are risk averse and are willing to pay to reduce risk—as when they buy insurance.
Various mental devices can help you assess your risks and deal with them, such as comparing your actual situation with hypothetical gambles with varying odds.
There are several principles for optimizing—maximization of “utility,” minimization of regret or surprise, and the mini-max principle. Trying to maximize your utility is the most reasonable criterion in almost all everyday situations.
Diversifying the situation in which you are involved—as, for example, in buying a variety of stocks rather than just one—can reduce your risk without reducing the benefits you gain from the activities.
Good Judgment
A key requirement for good judgment is strength of character, says my friend Max Singer. Integrity helps keep your judgment steady when the situation offers inducements to alter your conclusions.
Character may enable a person to act decisively in a situation where others also see the need to act, but the others continue to drift without facing up to what must be done. This is often the case with the decision to fire an employee. Many people shrink from that action, and fool themselves that perhaps the situation will improve. In contrast, the person with sound character and good judgment recognizes that the sooner the deed is done, the better for all.
Good judgment may be thought of simply as a collection of devices for avoiding the pitfalls that afflict human thinking or, more generally, devices for avoiding the pitfalls of life.
Good judgment implies sound balance between depth and breadth. The appropriate balance differs from situation to situation.
Good judgment in each situation usually includes asking questions that are important, and important because they are broad and overarching rather than because they are technically more advanced.
Having good judgment implies considering all the factors that need to be considered, and doing so at all times.In this sense, breadth of knowledge and understanding is the key element in good judgment. Taking into account the forces that come into play in the longer run are an important part of good judgment. Often this requires taking account of adjustment mechanisms that reverse the short-run phenomenon.
Taking account of the long-run and indirect effects is particularly important for understanding and forecasting the course of events in the economy and society as a whole.
Good judgment requires steadiness and constancy and an absence of lapses, a quality not required in more technical roles. A person serving in a top job responsible for the activities of an organization and other individuals must function well every day, whereas a scientist or artist who functions brilliantly on odd days but gets drunk on even days may be a great asset to the organization and to society.
This also implies that a person with good judgment must avoid being carried away by enthusiasms. It may even be an advantage not to have a copious flow of ideas. An executive can usually obtain satisfactory lists of alternatives from subordinates. One is naturally partial to ideas of one’s own. Therefore, not having ideas can help avoid unbalanced judgment. More generally, separating the task at hand from one’s own feelings —keeping ego and fears at bay is especially important—is an important element of good judgment.
My best suggestions to improve your judgment are
(1) obtain a wide range of experience, and
(2) rehearse the habit of asking yourself to check your judgment once more before arriving at a decision—asking yourself whether you have done everything possible to exert good judgment. This is why the greatest advantage of getting older is improved judgment. The more years you live, the more history you have seen, and the more opportunities you have had to see how a complex set of events play out, including the inborn propensities of human nature. This experience can prevent you from falling into pitfalls that younger people might fall into—if you learn from your experience, which is a big “if” indeed.
An important issue concerns the amount of trust to place in a person’s word or competence. Knowing how much faith to place in a consultant or in a prospective partner, for example, is a crucial aspect of an executive’s judgment. A child has more reason to believe a parent than a person at large, because a parent is more likely to have the child’s welfare at heart than does a stranger. And if a parent promises to protect you from danger, the parent has more at stake than does a stranger, and therefore is more reliable. Hence we expect youth to be more credulous than older persons who have had more time to acquire wider experience. Age does not guarantee acuity, however, and believing that it does would be an error of judgment.
The greatest affliction with respect to judgment is the belief of most people that they possess it. This is damaging because an important element of good judgment is humility about how little one knows. The most dangerous are the successful ones who have been getting praise for wielding the tools well. They are unaware that the judgmental aspects of law practice, say, have barely been discussed at law school. If you do not know what you lack, the lack cannot trouble you or affect your practice.
Youths also have not had the traumatic experiences of disaster that one inevitably acquires with time, and therefore youths may lack prudence. An older physician may be less likely than a younger one to advise surgery because she or he has known healthy people to die of anesthesia or complications. But of course this, too, can lead to poor judgment if the older person is so fearful that action is overly inhibited. Certainly it is bad judgment to overemphasize risks: Newspapers and television, which see themselves as watchdogs for the public, often do harm when they emphasize potential dangers—about the environment, for example—to the extent that our judgment about change is warped.
Setting priorities is another test of judgment. What should be done in which order? Which projects must be sacrificed under which conditions? What are the trade-offs? This requires that a person have sound intuition about relative values
A difficult judgment is whether to act now versus purchasing more information with waiting-time and money. It is possible to make some meaningful calculations of this tricky matter, but usually we rely on the decision-maker’s intuition.
The test of judgment is how often you are right relative to how often you are wrong. This is unlike the case of a scientist or artist in their actual work. What matters for those practitioners is not how often they are wrong, but rather how many good things they do, because the bad things they do are not very costly. Indeed, one scientist said that the job of a scientist is to make mistakes as fast as possible in order to save other scientists from having to make those mistakes. (Einstein put value on the then-unfruitful efforts of his last decades for just this reason.) In contrast, bad decisions are costly for managers; they matter as much as the good decisions. Of course a scientist or artist needs good judgment to choose projects that will turn out well, and in this respect they are functioning as managers rather than as artisans.
For more Information:
* Decision Making, Problem Solving, Negotiation, People Skill, People Management, Communication Skills, Business Success EBook, Emotional Intelligence, Social Intelligence, *
The strength of your desire to avoid risk is likely to depend upon your economic and life circumstances, and upon the size and nature of the risky outcomes.
But to avoid larger possible losses, you are willing to pay an insurance premium that costs more than the expected value of the loss, because such a loss could disrupt your life badly.
In practical terms, we want to know which choice we should make in a particular risky situation, such as purchasing insurance or opening a law office or choosing among investment opportunities in three countries that differ greatly in political stability.
There are two steps to a sound decision:
(1) Understand the nature of the risk and how it fits into the rest of your life (your business).
(2) Use appropriate devices for allowing for the cost to you of assuming the risk or the benefit of avoiding it.
Possible Criteria for Assessing Risk
These are some of the competing principles used in risk analyses, each associated with a different criterion goal for optimization:
1. Maximization of “utility.” The utility principle is the oldest and the most widely used device to allow for risk, especially among finance specialists, perhaps because it lends itself better to mathematical analyses than do the others. It aims to maximize your “utility”—that is, the supposed satisfaction that you might achieve from the resulting sums of money. It systematically takes into account that twice as much money will not give you twice as much satisfaction, the appropriate adjustment depending upon your wealth and the extent of your dislike for risk. All this has little or nothing to do with the concept of utility that Jeremy Bentham proposed in the eighteenth century, and from which the term originally comes. When you apply this principle, you reduce somewhat the expected value of the alternative you choose in order to reduce the variability among possible outcomes.
2. Minimization of regret or disappointment or unpleasant surprise. These related principles aim at reducing the chance that you will end up feeling badly about the outcome. For example, if someone first tells you that you have won a lottery and then two minutes later tells you that it was an error, you are likely to feel worse than if you had never heard either message. (Similarly, hearing from a doctor that you do not have a disease that you thought you might have had is likely to send you out in a particularly pleasant mood.) You therefore choose in a fashion by which you reduce somewhat the expected value of your choice in order to reduce the chance that the outcome will be one that will make you feel regret, disappointment, or unpleasant surprise.
3. The mini-max principle. This principle applies to some situations that are head-to-head games with one or more other players, in which you expect them to actively try to outfox you and where your loss is their gain. This is unlike most situations in life (and in business), where your relationship with the relevant groups of individuals (such as impersonal customers) or with nature (for example, when you are drilling an oil well) is not gamelike because your “opponent” is not actively trying to outfox you. The mini-max principle is a very complicated mathematical strategy for obtaining a combination of relatively large gains while taking the chance of relatively small losses, by attempting to avoid the worst situation that your opponent might force you into. This principle may be appropriate for some very specialized games and perhaps occasionally in war. But, to my knowledge, it has never been found appropriate in everyday life, despite all the inflated claims made for it. It is a classic example of the adepts of a fancy mathematical technique succeeding in a massive snow job on people who do not understand the mathematics but are so insecure about their ignorance that they take it on faith that there must be something of value inside the mysterious mathematical black box—something worth paying a high fee for. Unfortunately, cases like this are not rare in the world of “scholarship.”
The choice among these principles for dealing with risk depends upon your taste. But if your goal is to maximize profit in business, you will not make any allowance for risk other than that warranted by market (rather than personal) considerations.
Risk in a Business Setting
Lending or investing money is a common situation in which risk is a crucial issue. When a bank lends working capital to an individual or a firm, the interest rate depends upon how risky the bank deems the loan— that is, the bank’s estimate of the chance that the borrower will default. Similarly, the bonds of firms that are unstable or have little collateral must pay higher interest rates than do bonds of firms that are more solid. The stocks of firms whose prospects are very uncertain sell at a lower price relative to the firm’s earnings than do the stocks of firms whose earnings are stable and seemingly assured from year to year. And the rate of return to preferred stocks is on average higher than the rate of return to bonds, because in case of a bankruptcy the preferred stocks would lose their value before the bonds would. (Common stocks are riskiest of all in this respect.) This structure is equivalent, from the point of view of the person supplying the funds, to a lower discount factor for a more risky situation.
The Power of Diversification
You can go beyond making a single risky choice by arranging your “portfolio” of risk-taking activities so as to reduce the total risk. For example, instead of investing all your wealth in a single stock, you can diversify among a set of stocks. A life insurance company greatly reduces its risk by selling a great many insurance policies rather than just one.
Almost any diversification reduces the overall risk even while keeping the returns the same. But it is not possible to eliminate all risk with diversification.
Summary
People pay to increase their risk when they gamble. But aside from situations where risk is exciting, people generally are risk averse and are willing to pay to reduce risk—as when they buy insurance.
Various mental devices can help you assess your risks and deal with them, such as comparing your actual situation with hypothetical gambles with varying odds.
There are several principles for optimizing—maximization of “utility,” minimization of regret or surprise, and the mini-max principle. Trying to maximize your utility is the most reasonable criterion in almost all everyday situations.
Diversifying the situation in which you are involved—as, for example, in buying a variety of stocks rather than just one—can reduce your risk without reducing the benefits you gain from the activities.
Good Judgment
A key requirement for good judgment is strength of character, says my friend Max Singer. Integrity helps keep your judgment steady when the situation offers inducements to alter your conclusions.
Character may enable a person to act decisively in a situation where others also see the need to act, but the others continue to drift without facing up to what must be done. This is often the case with the decision to fire an employee. Many people shrink from that action, and fool themselves that perhaps the situation will improve. In contrast, the person with sound character and good judgment recognizes that the sooner the deed is done, the better for all.
Good judgment may be thought of simply as a collection of devices for avoiding the pitfalls that afflict human thinking or, more generally, devices for avoiding the pitfalls of life.
Good judgment implies sound balance between depth and breadth. The appropriate balance differs from situation to situation.
Good judgment in each situation usually includes asking questions that are important, and important because they are broad and overarching rather than because they are technically more advanced.
Having good judgment implies considering all the factors that need to be considered, and doing so at all times.In this sense, breadth of knowledge and understanding is the key element in good judgment. Taking into account the forces that come into play in the longer run are an important part of good judgment. Often this requires taking account of adjustment mechanisms that reverse the short-run phenomenon.
Taking account of the long-run and indirect effects is particularly important for understanding and forecasting the course of events in the economy and society as a whole.
Good judgment requires steadiness and constancy and an absence of lapses, a quality not required in more technical roles. A person serving in a top job responsible for the activities of an organization and other individuals must function well every day, whereas a scientist or artist who functions brilliantly on odd days but gets drunk on even days may be a great asset to the organization and to society.
This also implies that a person with good judgment must avoid being carried away by enthusiasms. It may even be an advantage not to have a copious flow of ideas. An executive can usually obtain satisfactory lists of alternatives from subordinates. One is naturally partial to ideas of one’s own. Therefore, not having ideas can help avoid unbalanced judgment. More generally, separating the task at hand from one’s own feelings —keeping ego and fears at bay is especially important—is an important element of good judgment.
My best suggestions to improve your judgment are
(1) obtain a wide range of experience, and
(2) rehearse the habit of asking yourself to check your judgment once more before arriving at a decision—asking yourself whether you have done everything possible to exert good judgment. This is why the greatest advantage of getting older is improved judgment. The more years you live, the more history you have seen, and the more opportunities you have had to see how a complex set of events play out, including the inborn propensities of human nature. This experience can prevent you from falling into pitfalls that younger people might fall into—if you learn from your experience, which is a big “if” indeed.
An important issue concerns the amount of trust to place in a person’s word or competence. Knowing how much faith to place in a consultant or in a prospective partner, for example, is a crucial aspect of an executive’s judgment. A child has more reason to believe a parent than a person at large, because a parent is more likely to have the child’s welfare at heart than does a stranger. And if a parent promises to protect you from danger, the parent has more at stake than does a stranger, and therefore is more reliable. Hence we expect youth to be more credulous than older persons who have had more time to acquire wider experience. Age does not guarantee acuity, however, and believing that it does would be an error of judgment.
The greatest affliction with respect to judgment is the belief of most people that they possess it. This is damaging because an important element of good judgment is humility about how little one knows. The most dangerous are the successful ones who have been getting praise for wielding the tools well. They are unaware that the judgmental aspects of law practice, say, have barely been discussed at law school. If you do not know what you lack, the lack cannot trouble you or affect your practice.
Youths also have not had the traumatic experiences of disaster that one inevitably acquires with time, and therefore youths may lack prudence. An older physician may be less likely than a younger one to advise surgery because she or he has known healthy people to die of anesthesia or complications. But of course this, too, can lead to poor judgment if the older person is so fearful that action is overly inhibited. Certainly it is bad judgment to overemphasize risks: Newspapers and television, which see themselves as watchdogs for the public, often do harm when they emphasize potential dangers—about the environment, for example—to the extent that our judgment about change is warped.
Setting priorities is another test of judgment. What should be done in which order? Which projects must be sacrificed under which conditions? What are the trade-offs? This requires that a person have sound intuition about relative values
A difficult judgment is whether to act now versus purchasing more information with waiting-time and money. It is possible to make some meaningful calculations of this tricky matter, but usually we rely on the decision-maker’s intuition.
The test of judgment is how often you are right relative to how often you are wrong. This is unlike the case of a scientist or artist in their actual work. What matters for those practitioners is not how often they are wrong, but rather how many good things they do, because the bad things they do are not very costly. Indeed, one scientist said that the job of a scientist is to make mistakes as fast as possible in order to save other scientists from having to make those mistakes. (Einstein put value on the then-unfruitful efforts of his last decades for just this reason.) In contrast, bad decisions are costly for managers; they matter as much as the good decisions. Of course a scientist or artist needs good judgment to choose projects that will turn out well, and in this respect they are functioning as managers rather than as artisans.
For more Information:
* Decision Making, Problem Solving, Negotiation, People Skill, People Management, Communication Skills, Business Success EBook, Emotional Intelligence, Social Intelligence, *
