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Friday, December 20, 2013

Positive Risk

It seems to be fashionable for risk specialists of all creeds to strive to become yes people rather than the 'No Obstruction Control Hurdle' everyone in a business generally detests. Yet, to truly embrace the innovation potential withing risk management is going to require risk managers to chase the positive aspects of risk.

Risk managers will need to explore the optionality in a risk before risk management can evolve into a yes sport as opposed to the party pooper it often ends up being.

The opportunity in risk

The age old saying "within risk lies opportunity" is nothing new, the Chinese characters have been crafted this way but as much as one would like to believe, this is still not perceiving risk in a positive manner. It is anchoring risk as the downside of opportunity but that doesn't make opportunity positive risk. At best, there is a flow between risk and opportunity where a risk is transformed into an opportunity, now that would be positive risk but the opportunity alone is not positive risk.

Is this a bargain or is this a risk is fundamentally a misunderstanding of where and how risk, opportunity and expectation cohabitate. Not being able to interpret the boundaries between these places can confuse traders, often leading them to make very poor decisions. 

We have adversity which is a hazard to us but we re-frame our thinking and try to 'recover' positively from that uncertainty. Concisely, our recovery action is still an attempt to avoid risk and loss, it is not an opportunity from the outset.

The general modus operandi business managers run with kind of goes along the following lines: We have an objective which may potentially benefit us but whether that business strategy is successful or not is uncertain and entertaining that objective might have negative outcomes which need to be controlled. Risk in this case is very much being seen as negative and there is no optionality here unless we engineer these negative outcomes into potential future opportunities where we can win either way.

Before we go hunting for risk rather than avoiding it, perhaps we can ponder on the opportunity being the threat while risk is the goal, just for a moment and why not? ... If risks can be turned into opportunities, surely opportunities could be converted into risks. May be this positive risk in retrospect.

Over Performance

It is possible then that an opportunity can be too rich for us or perhaps too successful and while this may seem strange to conceive, poor planning around the uncertainty in growth forecasts can result in disastrous outcomes.

In the above example, misunderstanding the positive effects in the objective has resulted in unwanted consequences and the opportunity has become the risk.

Vega Hunters

Mature investors don't perceive risk as a negative thing, risk is valuable to them because within risk there is yield.

A volatility investor looks for falling asset prices and shorts them, they look for rising asset prices and buy into that directional movement, they look for those that fear uncertainty and sell them options. To this type of investor, the higher the variance in asset prices, the higher the potential for profit taking but such increases in uncertainty directly translate to risk when no contractual optionality is present.

Viewing risk in a context this marries uncertainty to volatility makes risk less epistemic in nature, it ties the stakeholder's success to the sensitivity in how they model and manage uncertainty within a band of standard error.

Buying into or selling out of uncertainty in this 'risk neutral' way is now not anchored on its directional movement of negative versus positive but rather it ties it to volatility or the flow between these two polar places.

Additionally, risk is also entirely positive from the outset in the context of this strategy. All this aside, I generally only see asset managers or advanced investors approaching risk management in this type of manner.

Risk Underwriters

There are others in the world of risk that profit directly from the downside of uncertainty, they pray on the fear of those impacted by threats and underwrite the solution to transfer this risk away. To the insurer, risk is again entirely the opportunity and to the insured, they pay dearly in premiums to hand over parcels of risk through time.

Embracing Adversity

After looking at these three examples above, it becomes relatively apparent that risk is not just a negative thing we must have aversion to because it can be found in positive outcomes and to the unwary, more risk is actually a profitable business to be in. Well, it does seem to be for a while at the very least.

So now we have debased the concept that risk is always negative, where is the best place to operate?
Convex payoffs benefit from uncertainty and disorder or perhaps when we have the option to take on what serves us and discard what does not. We add an ingredient, say a spice, taste it to see if there is an improvement from the complex interaction, and retain if we like the addition or discard the rest. Critically we have the option, not the obligation to keep the result, which allows us to retain the upper bound and be unaffected by adverse outcomes.
The poor substitute for convexity | The Edge, Nassim Taleb [LINK]
Here is the crunch, if you truly want to design systems that benefit from risk, they are going to need to be convex rather than concave. That is how Nassim Taleb describes it and the innovation to be found in risk management should feed off adversity rather than be harmed by it. Yet, most compliance related risk management processes or controls are usually too focused on instilling the doctrine that aversion to volatility is a good thing and risk is a bad place to exist. All this aside, if we are able to start seeing the optionality in risk, the place between positive and negative becomes less directional, then risk management stands a chance of eventually being a true yes sport.

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