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The world is not a risk-management textbook!

Accordingly to Nicholas Taleb, no forecasting model predicted the impact of the current economic crisis! Also, its consequences continue to take establishment economists and business academics by surprise.

The banks had their own risk-management models. Did they warn them of the financial crisis before it occurred?
According to him, low-probability yet high-impact events are almost impossible to forecast. Thus, we call them Black Swan events. We have read about this phenomenon in our previous post.

Black-Swan

The world is becoming more and more complex day by day. The solution is to reduce our vulnerability to them. We can prepare ourselves by adapting to newer technology like VComply which will help a company asses risks of compliance and governance before they occur! Risks cannot be eliminated. Hence, we can only lessen the impact of what we don’t understand. Thus, it doesn’t remain a a futile attempt to develop sophisticated techniques and stories that perpetuate our illusions of being able to understand and predict the social and economic environment.

To change the way we think about risk, we must avoid making six mistakes.

1. We assume we can predict extreme events

We neglect other possibilities which are in plain sight in order to forecast something extreme. In the process, we become more vulnerable.

Company’s energy can be focused on preparing for the eventualities. They should try to evaluate the effect of the event. What will be its impact on demand or supply?

2. We are convinced that studying the past will help us manage risk

Risk managers mistakenly use hindsight as foresight. Alas, our research shows that past events don’t bear any relation to future shocks.
We often hear those employed in the financial services industry say “This is unprecedented.” They assume that they can find precedents to anything and predict everything.

But Black Swan events don’t have precedents. There is a certain randomness inherent to many variables. Because of socioeconomic randomness, there’s no such thing as a “typical” failure or a “typical” success. There are typical heights and weights, but there’s no such thing as a typical victory or catastrophe.

It is necessary to predict an event and its riskiness. It is tough since the result is not typical.

VComply

3. We don’t listen to advice about caution.

The “don’ts” are usually more ignored. There is a difference between commission and omission. Although their impact is the same, risk managers should not treat them equally. It places a greater emphasis on earning profits than they do on avoiding losses.

A company can be successful by preventing losses. In chess, grand masters focus on avoiding errors; rookies try to win. Not losing almost half your retirement is undoubtedly a victory. Books are full of success stories. Nobody speaks about failure! Risk-management activities should be integrated with profit making mindset, particularly if the companies are susceptible to rare impactful events.

4. Can risk be only measured by standard deviation?

Standard deviation—used extensively in finance as a measure of investment risk—shouldn’t be used in risk management, according to Mr. Taleb. He says that people misuse and misunderstand its real meaning. In any case, anyone looking for a single number to represent risk is inviting disaster.

5. We are taught that optimizing shareholder value should not follow redundancy

Optimization makes companies vulnerable to changes in the environment. Biological systems cope with change; Mother Nature is the best risk manager of all. That’s partly because she loves redundancy. Evolution has given us spare parts—we have two lungs and two kidneys, for instance—that allow us to survive.

In the corporate world, redundancy means inefficiency: idle capacities, unused parts. Leverage, is considered good. Yet, we all know that debt makes companies fragile. Also, if you aren’t carrying debt on your books, you can cope better with changes.

Remember that the biggest risk lies within us: We overestimate our abilities and underestimate what can go wrong. Any corporation that doesn’t recognize its Achilles’ heel is fated to die because of it.

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