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Views from the Prairie

November 08

How much risk can you stand?

The last few years of the stock and oil markets have been like a car full of teenagers after a party: high speed, fast corners, and then, a sudden sobering clash with reality. With that in our rear view mirror, it helps to look at how people handle risk. We, humans, react to perceived risk rather than actual risk, have different tolerances of risk in different areas of our lives, and we handle risk in different ways.

When a sixteen year old is handed the keys to the car for the first time, they have no concept of the risks they are taking. They certainly don't have any idea of what fears are running through their parents' minds. They simply want to drive. And in that difference, we see how people of different ages perceive risks. I've heard that people do not start to understand risks properly until they are in their thirties.

Part of the problem with identifying how people react to risks is that people handle risks in different parts of their lives differently. People can have different risk profiles in the physical realm from that of the financial, social, or ethical realm. So, a teenager may be so focused on avoiding social disapproval that they take drugs, shoplift, or drive recklessly - take financial, ethical, and physical risks. Other people may be so focused on avoiding financial risks that they take ethical risks.

Different people have different levels of risk that they are comfortable living with. This difference has deep implications for government regulations. We have mandated numerous safety improvements to automobiles and roadways. Yet, people still have accidents. What happens is that those who like to take greater risks drive more recklessly _because_ their cars are safer.

The same thing happens in the financial world. Different people are comfortable with different levels of financial risk. We have seen attempts to use politics to change how much risk people have; communism removed many financial risks from the common people while putting major risks on the society as a whole. We see the financial regulators in this country try to manage risks and put in limits. Yet, nothing totally works. People who like risk will find ways around the rules and regulations to be able to take those risks.

The other problem is that people react not to the real risks, but to the perceived risks that they are taking. What happened to the stock market and to the banks was that people perceived the risks they were taking to be non-existent. Suddenly, the risks happened and they over reacted with assigning large risk to everything. We saw the same thing in the S&L crisis in Texas. Numerous people reported that when their bank went under, the regulators forced many a loan to be classified as high risk when previously it had been thought of as low risk.

People react to risk in many ways; with fatalism, unconcern, control attempts, and with management. Each of these is due to our personality and appetite for risk. Fatalism is where we accept whatever happens. Those who react with unconcern are like your stock broker who is making phone calls to get you to buy stock after a 3,000 point drop of the Dow Jones Index. It is almost like they are oblivious to the risks that you just saw. Those who react to risk with control are trying desperately to avoid whatever they see as the risk. So, they want to set up a "Carbon emission" trading to try to prevent a future problem. They are often ahead of the curve on the actual risks and can miss when the situation changes. The people who react to risk with trying to manage it are your natural insurance actuaries. They figure out what the risks are and how to spread it out and how to avoid the extremes.

What does all this mean for a manager? It means that people will react to situations in very different ways. When a company is going through tough times, some people will react fatalistically - they can't help the situation. Others will react as if the sky is falling. Still others will figure out how they can use the unsettled times to get ahead of the rest. Managers do well to gauge the risk tolerance and deal with the different ways people react.

Life is not simple and neither are humans.


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