Risk
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- This article is about the concept of risk. There is also a popular board game named Risk, and an album by Megadeth named Risk.
Risk is the potential harm that may arise from some present process or from some future event. It is often mapped to the probability of some event which is seen as undesirable. Usually the probability of that event and some assessment of its expected harm must be combined into a believable scenario (an outcome) which combines the set of risk, regret and reward probabilities into an expected value for that outcome. There are many informal methods which are used to assess (or to "measure" although it is not usually possible to directly measure) risk, and (for some applications) formal methods such as value at risk.
In futures trading Risk, is a loss of trading capital.
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Risk is different from threat
In scenario analysis "risk" is distinct from "threat." A threat is a very low-probability but serious event - which some analysts may be unable to assign a probability in a risk assessment because it has never occurred, and for which no effective preventive measure (a step taken to reduce the probability or impact of a possible future event) is available. The difference is most clearly illustrated by the precautionary principle which seeks to reduce threat by requiring it to be reduced to a set of well-defined risks before an action, project, innovation or experiment is allowed to proceed.
A more specific example is the preparedness of the United States of America prior to the devastating attack on September 11th, 2001. Although the Central Intelligence Agency had often warned of a "clear and present danger" of using planes as weapons, this was considered a threat, not a risk. Accordingly, no comprehensive scenarios of probabilities and counter-measures were ever prepared for the type of attack that occurred. Taking a frequentist probability approach, a threat cannot be characterized as a risk without at least one specific incident wherein the threat can be said to have "realized". From that point, there is at least some basis to characterize a probability, e.g. "in the entire history of air travel, X flights have led to 1 incident of..." By contrast Bayesian probability methods would allow threats to be assigned a degree of belief, even if they had never happened before, and this could then be treated as a probability.
In information security a "risk" is defined as the probability that a threat will act on a vulnerability to cause an impact, in other words a risk represents the chance coincidence of all three elements. Threats in this context include deliberate/directed acts (e.g. by crackers) and undirected/random/unpredictable events (such as a lightening strike). Vulnerabilities are generally caused by weaknesses in the system of preventive controls, including missing or ineffective procedural or technical controls, bugs in systems etc. Impacts are adverse effects on organizations, individuals or indeed society at large. A vulnerability is not an issue per se unless a threat exploits it and causes an impact. Risk management therefore involves minimizing the threats, vulnerabilities and/or impacts.
Professions and governments manage risk
Means of measuring and assessing risk vary widely across different professions--indeed, means of doing so may define different professions, e.g. a doctor manages medical risk, a civil engineer manages risk of structural failure, etc.
A professional code of ethics is usually focused on risk assessment and mitigation (by the professional on behalf of client, public, society or life in general).
Some theorists of political science, notably Carol Moore and Jane Jacobs, emphasize that smaller political units and careful separation of the roles of regulator and trader can improve professional ethics and subordinate them to uniform risk limits that would apply to a particular locale, e.g. an entire urban area.
The political ideal of bioregional democracy arose in part in response to these ideals, and problems of professional jargons and associations alienating power from real people living in real places.
"A profession by definition is in a conflict of interest with respect to the risk passed on to its clients." - Steven Rapaport.
Risk-Sensitive Industries
Some industries manage risk in a highly-quantified and numerate way. These include the nuclear and aircraft industries, where the possible failure of a complex series of engineered systems could result in highly undesirable outcomes. The usual measure of risk is then
Risk = Probability times Consequence.
The risks are evaluated using Fault Tree/Event Tree techniques (see safety engineering). Where these risks are low they are normally considered to be 'Broadly Acceptable'. A higher level of risk (typically up to 10 to 100 times BA) has to be justified against the costs of reducing it further and the possible benefits that make it tolerable - these risks are described as 'Tolerable if ALARP'. Risks beyond this level are of course 'Intolerable'.
The level of risk deemed 'Broadly Acceptable' has been considered by Regulatory bodies in various countries - an early attempt by UK government regulator & academic F. R. Farmer used the example of hill-walking and similar activities which have definable risks that people appear to find aceptable.
The technique as a whole is usually refered to as Probabilistic Risk Assessment (PRA).
Risk as regret
Risk has no one definition, but some theorists, notably Ron Dembo, have defined quite general methods to assess risk as an expected after-the-fact level of regret. Such methods have been uniquely successful in limiting interest rate risk in financial markets. Financial markets are considered to be a proving ground for general methods of risk assessment.
However, these methods are also hard to understand. The mathematical difficulties interfere with other social goods such as disclosure, valuation and transparency.
In particular, it is often difficult to tell if such financial instruments are "hedging" (decreasing measurable risk by giving up certain windfall gains) or "gambling" (increasing measurable risk and exposing the investor to catastrophic loss in pursuit of very high windfalls that increase expected value).
As regret measures rarely reflect actual human risk-aversion, it is difficult to determine if the outcomes of such transactions will be satisfactory. Risk seeking describes an individual who cares more about the potential gains than about the expected gains from an investment. For example, an individual who invests in a small stock, knowing there is a large chance of losing some money, but a small chance of making a great deal of money could be described as a risk seeker.
In financial markets one may need to measure credit risk, information timing and source risk, probability model risk, and legal risk if there are regulatory or civil actions taken as a result of some "investor's regret".
Tough choices
Financial markets illustrate a more general problem in defining and assessing risk-- the ways that different types of risk combine.
It can be hard to see how the relative risks from different sources should affect one's decisions. For example, when treating a disease a doctor might have the choice of either using a drug that had a high probability of causing minor side effects, or carrying out an operation with a low probability of causing very severe damage.
According to the regret theory, the only way to resolve such dilemmas might be to find out more about the patient's life and ambitions. If, for instance, the patient's greatest desire centered on raising children, one might prefer the drug even if it limited their mobility or physical capacity somewhat. However, if the patient has already risked their own life several times in extreme sporting events, the decision to do so one more time and recover full capacities may be far preferable.
This highlights a major problem in professional ethics: knowing when the cognitive bias of the professional versus the client (or "patient") must dominate, and what choices each is best able to make.
Framing
Framing is a fundamental problem with all forms of risk assessment. The above examples: body, threat, price of life, professional ethics and regret show that the risk adjustor or assessor often faces serious conflict of interest. The assessor also faces cognitive bias and cultural bias, and cannot always be trusted to avoid all moral hazards. This represents a risk in itself, which grows as the assessor is less like the client.
For instance, an extremely disturbing event that all participants wish not to happen again may be ignored in analysis despite the fact it has occurred and has a nonzero probability. Or, an event that everyone agrees is inevitable may be ruled out of analysis due to greed or an unwillingness to admit that it is believed to be inevitable.
These human tendencies to error and wishful thinking often affect even the most rigorous applications of the scientific method and are a major concern of the philosophy of science.
But all decision-making under uncertainty must consider cognitive bias, cultural bias, and notational bias: No group of people assessing risk is immune to "groupthink": acceptance of obviously-wrong answers simply because it is socially painful to disagree.
One effective way to solve framing problems in risk assessment or measurement (although some argue that risk cannot be measured, only assessed) is to ensure that scenarios, as a strict rule, must include unpopular and perhaps unbelievable (to the group) high-impact low-probability "threat" and/or "vision" events.
This permits participants in risk assessment to raise others' fears or personal ideals by way of completeness, without others concluding that they have done so for any reason other than satisfying this formal requirement.
For example, an intelligence analyst with a scenario for an attack by hijacking might have been able to insert mitigation for this threat into the U.S. budget. It would be admitted as a formal risk with a nominal low probability. This would permit coping with threats even though the threats were dismissed by the analyst's superiors.
Even small investments in diligence on this matter might have disrupted or prevented the attack-- or at least "hedged" against the risk that an Administration might be mistaken.
Insurance
Although military decision making tends to dominate risk theory, its most sophisticated daily practice is in the insurance industry,
The insurers have well-defined roles of actuary, underwriter, agent, auditor and adjustor. Each of these is an assessor in somewhat different circumstances or stages of the insuring, reinsuring, adjustment, recovery and claims payment processes.
Military leads Insurance leads finance leads government
In very broad terms, military and insurance decision making is quite a bit more formal and sophisticated than equivalent processes in financial markets - the regret theory has done much to equalize this by incorporating many common military and insurance practices, and putting formal trappings on them.
Generally, the military, insurance, financial, and other professional fields must work through methods before they become prevalent in government policy.
Risk assessments with differing ways of determining public concerns are a major concern of political parties. These parties compete to impose these views on foreign policy, the judicial system, law enforcement, and in Legislation.
The techniques flow slowly from one field to the next. To illustrate the long timelines involved, scenario analysis matured during Cold War confrontations between major powers, notably the USA and USSR, but was not widespread in insurance circles until the 1970s when major oil tanker disasters forced a more comprehensive foresight. It entered finance until the 1980s when financial derivatives proliferated. It did not reach most professions in general until the 1990s when personal computers proliferated.
Governments are apparently only now learning to use sophisticated risk methods, most obviously to set standards for environmental regulation, e.g. "pathway analysis" as practiced by the US EPA.
Civilization as risk-reduction?
"Civilization advances by extending the number of important operations which we can perform without thinking about them." - Alfred North Whitehead.
If Whitehead is right, then the perfect civilization is the perfect risk reduction algorithm-- capable of warning us long in advance of foreseeable problems, and assuring us that surprises were unforeseeable in principle.
Unfortunately, this vision of a risk-reducing symbiote or prosthetic for human judgement remains elusive, fragmented, and unlikely to be realized.
Fear as intuitive risk assessment?
For the time being, we must rely on our own fear and hesitation to keep us out of the most profoundly unknown circumstances.
In "The Gift of Fear", Gavin de Becker argues that "True fear is a gift." (from book jacket) "It is a survival signal that sounds only in the presence of danger. Yet unwarranted fear has assumed a power over us that it holds over no other creature on Earth. It need not be this way."
Risk could be said to be the way we collectively measure and share this "true fear" - a fusion of rational doubt, irrational fear, and a set of unquantified biases from our own experience.
The field of behavioral finance focuses on human risk-aversion, asymmetric regret, and other ways that human financial behavior varies from what analysts call "rational". Risk in that case is the degree of uncertainty associated with a return on an asset.
A recognition of, and respect for, the irrational influences on our decisions, may go far in itself to reduce disasters due to naïve risk assessments that pretend to rationality but in fact merely fuse many shared biases together:
"This above all, to refuse to be a victim." - Margaret Atwood
Papers
Holton, Glyn A. (2004). Defining Risk (http://www.riskexpertise.com/papers/risk.pdf), Financial Analysts Journal, 60 (6), 19–25. A paper exploring the foundations of risk. (PDF file)
Books
A good example for a risk-controlling, yet utopian civilisation was written by Ian M. Banks in his science fiction Culture novels.
See also
Topics
- Credit risk
- Interest rate risk
- Legal risk
- Liquidity risk
- Market risk
- Operational risk
- Systemic risk
- Value at risk
- Volatility risk
- Glossary (http://www.risk-glossary.com/)
- Whitehead quotations (http://www-groups.dcs.st-and.ac.uk/~history/Quotations/Whitehead.html)
- Certainty equivalents applet (http://www.gametheory.net/Mike/applets/Risk/)
Magazines
- Risk and Insurance : Home (http://www.riskandinsurance.com/)
- Actuarial News And Risk Management Resource : Home (http://www.actuarialnews.org/)