Contingencies Online - September/October 2009

The Law of Risk and Light

“In the country of the blind, the one-eyed man is king.”
—Erasmus, Adagia

IT’S WIDELY REPORTED that markets are made because partici-
pants have different views of the opportunities in the market. For every
transaction, there may be an agreement on price but also an inevitable
complete disagreement on the direction of the next move in price. One
source for these differing opinions is the differing views of risk held by
various market participants. In this article, I’ll take a look at five com-
mon perspectives on risk and see how they affect not just each partici-
pant’s own choices but everyone else’s choices, as well.

Five Common Views of Risk 1. EYES SHUT—Some risk-takers firmly believe that real rewards come only to those who take risks blindly; they think that caution, preparation and analysis will generally result in avoiding those opportunities that have the best payoffs. Many successful entrepreneurs share this eyes-shut view. They are often the visionaries who stick to their dream in the face of all the naysayers. Are these people phenomenally talented, or just lucky? Even if the eyes-shut entrepreneurs follow completely random strategies, one out of 100 might be wildly successful. That one will be celebrated in the press, while the 99 losers are quickly forgotten. Perhaps some of these individuals are indeed transcendentally talented, but I will proceed under the assumption that there are too few such supermen to worry about. 2. QUICK LOOK—These risk-takers apply an approach that is tried and true, often based on practical rules of thumb. If the situation is familiar, they immediately turn to their usual method of risk

selection. Unfamiliar risks are rejected, generally without further thought or analysis. The reward for the quick-look

view of risk is often relatively low. But
the risk is generally low, as well.
3. ONE-EYED—This perspective adopts
a single specific quantitative mea-
sure of risk. The two most common
examples are volatility and ruin prob-
ability. Defining risk as volatility is the
basis for modern portfolio theory, the
Black-Scholes-Merton model and pric-
ing methods based on risk margin as a
function of standard deviation. The ruin
theory (or cost of risk capital) approach

defines risk (or capital) as a function of the loss potential in an extremely remote situation.

4. TWO-EYED—In this blended approach, the risk-taker seeks compensation for both volatility and the possibility of ruin—or at least seeks to avoid extremes of one or the other.

5. MULTIDIMENSIONAL—Risk managers with a multidimensional view consider volatility, ruin and everything in between. In addition, they consider risk factors such as parameter risk, correlation, market cycles, liquidity and execution risk. They include not only types of risk that are readily quantifiable but also those that may be extremely difficult to measure.

The choice of which view of risk is the best isn’t immediately obvious. There are several strengths and weaknesses to each approach, as summarized in Table 1.

Each risk view will tend to drive the firm’s risk portfolio in a certain direction. Most important, risks that are “in the light” (i.e., recognized by the prevailing risk view) will be managed, mitigated or avoided, while risks that remain “in the dark” (i.e., unrecognized by the prevailing risk view)