LESSONS IN RISK MANAGEMENT and BUSINESS STRATEGY
By Brett Sherman, The Sherman Law Firm
Thanks to Nassim Nicholas Taleb and Jim Grant.
High Risk Strategies Fail In the Long Run - See, for example, Bear Stearns 1. The definition of risk is the chance of loss. If an action carries a chance of loss, it is risky. The greater the chance of loss, the greater the risk. Risk magnitude refers to the size of potential loss. If the potential loss from a given risk could wipe you out, the magnitude is very high. 2. Why do high risk strategies threaten long-term survival? Think of betting your life savings on a game of Russian Roulette.[1] Once a year, on New Year’s Eve, you hold a cold steel pistol to your temple. The gun has six chambers, but only one holds a bullet. You say a little prayer and squeeze the trigger. Each year your luck holds, you exhale with relief. You have drawn one of the five lucky chambers. Then you jump for joy. You not only get to live, but you’ve just doubled your money. 3. Unfortunately, each year that you win the laws of probability and statistics stack up higher and higher against you. Luck doesn’t last forever, and math never lies. Next year, your luck may run out. In any event, if you play for too long, you are almost guaranteed to lose. 4. Of course, losing at Russian Roulette means losing everything you’ve ever had and everything you ever will have.[2] Therefore, “prudent risk management” (to use the words of former Bear Stearns CEO Jimmy Cayne) dictates that you shouldn’t be playing the game at all. The bet is far too risky. But it is also quite lucrative, and you really like money. You understand the chance you are taking. You take it anyway. You are just like the Executive Committee at Bear Stearns. 5. The point is this - Frequency of success does not mean anything if the cost of even one failure is too high. Bear Stearns reported record revenues for 5 straight years. And when the company collapsed, those record years didn’t matter to public shareholders at all (except for those lucky enough to have had a reason to sell BSC long before March 2008). 6. The individuals who truly benefitted from each of those five record years were the Executive Committee members. They received windfall bonuses, including many millions in cash payments, for generating positive short-term performance during an unprecedented bull market.
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