Risk Management in Today's Economy

Jose D. Roncal

www.financialspeculation.com

It's a generally accepted fact that to be successful, you have to be willing to take risks. When you consider the practices of contemporary entrepreneurs like Sir Richard Branson, Frederick A. Smith, or Donald Trump, to name a few, it's hard to argue with the fact that these high-rolling risk-takers have not only realized success, they've also contributed to the economy by creating countless jobs for others.  

But in today's dire financial situation, the very concept of risk-taking is taking a major beating.  Who is responsible for this disaster? Was anybody minding the store? What happened to the practice of enterprise risk management (ERM)?  Everybody is anxious to point fingers at somebody else, but no need to crowd folks; there's plenty of blame to go around.

With so many companies going belly up, it might appear that ERM has failed us. But we think the current financial crisis did not result from a failure of ERM, but a rather failure to properly implement the ERM process.

I've had years of experience in directing corporate turnarounds and can remember a time when Specialist Forecasting was straightforward.  By the end of the first quarter, managers usually had a reasonably reliable sense of how the business was doing and whether targets were going to be met, missed or exceeded.

These were the numbers that ruled the markets. Investors placed such a high level of confidence in quarterly and annual predictions, if the numbers were off just a few points above or below projections, it was enough to create huge moves in the stock value. This year, however, things have changed. Suddenly the act of announcing projections has become a risky business, and some companies are not making any predictions about their future performance.

It's not that these firms are hesitant to provide a dismal outlook, if that's their financial situation. It's that there is so much uncertainty in the markets they can't feel confident in even making projections.

What is needed is actually very fundamental: the ability to manage risk. We now have sophisticated tools to help in managing financial risk—complex mathematical models analyze potential outcomes and probabilities, based on past performance.  There has been a growing reliance on these models, yet many of them failed to predict or alert companies to the current global economic crisis.  Today those that were responsible for building the models have taken the brunt of the blame for the financial meltdown.

Does this mean that the models failed?  No, because models are only as good as the decisions made after reading the numbers. Even if models accurately report the extent of a potential risk, a mistake in estimating the odds of it happening can lead to a disastrous conclusion.

The current crisis should serve as a wake-up call for companies to take a long hard look at their past approaches to risk management and to start making adjustments for the future.  Managers can no longer separate risks into isolated categories like operational risk, market risk, credit risk and so on.  They need to have a broader view and take a more integrated approach to risk.

If you need a glaring example of what can go wrong when you isolate risk factors, consider the Wall Street trading desks. These traders were experts in managing market risk, but because they were trading instruments that were fraught with credit risk, they were blind-sighted to the impending global meltdown. It's become clear that each risk category requires it's own knowledge bank, and without an integrated team of specialists, companies are vulnerable to major problems.

How do you identify and avoid risk or use it to your advantage? We cover this topic in great detail in our book, The Big Gamble: Are You Investing or Speculating.  Chapter two, entitled Risk: The Oxygen of Finance, covers the history of risk and the psychology of risk, as well as the various categories of financial risk such as inflation, interest rates, credit or default risk, market or systemic risk.  

You will also find references to Peter Bernstein’s 1998 book, Against the Gods: The Remarkable Story of Risk, in which he describes man’s struggle to understand risk and probability.  When addressing the dangers of relying too heavily on computer models, Bernstein wrote, "Nothing is more soothing or more persuasive than the computer screen, with its imposing arrays of numbers, glowing colors and elegantly structured graphs. As we stare at the passing show, we become so absorbed we tend to forget that the computer only answers questions; it does not ask them.... Those who live only by the numbers may find that the computer has simply replaced the oracles to whom people resorted in ancient times for guidance in risk management and decision-making."

If you'd like to know more about the successful speculators mentioned above, we devote an entire section of our book, The Big Gamble, to these and many others, starting with the turn-of-the-20th-century robber barons right up to the modern day cyber-gurus that created Amazon and Google.You can order our book here.

If you found this article helpful, visit www.financialspeculation.com to claim your own copy of Jose Roncal's popular FREE REPORT, "12 Keys to Smart Speculating in Tough Times." It's chock full of valuable insight on how to rebuild your nest egg. While you are there, check out "The Big Gamble: Are You Investing or Speculating?" See for yourself why Donald Trump has called it "a great read!"

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