Leave Something on the Table

What was the difference between the banks and insurers with high tech risk management programs that did extremely poorly in the GFC from those with equally high tech risk management programs who did less poorly?

One major difference was the degree to which they believed in their models.  Some firms used their models to tell them exactly where the edge of the cliff was so that they could race at top speed right at the edge of the cliff.  What they did not realie was that they did not know, nor could they know the degree to which the edge of that cliff was sturdy enough to take their weight.  Their intense reliance on their models, most often models that focused like a lazer on the most important measure of risk, left other risks in the dark.  And those other risks undermined the edge of the cliff.

Others with equally sophisticated models were not quite so willing to believe that it was perfectly safe right at the edge of the cliff.  They were aware that there were things that they did not know.  Things that they were not able to measure.  Risks in the dark.  They took the information from their models about the edge of the cliff and they decided to stay a few steps away from that edge.

They left something on the table.  They did not seek to maximize their risk adjusted returns.  Maximizing risk adjusted return in the ultimate sense involved identifying the opportunity with the highest risk adjusted return and taking advantage of that opportunity to the maximum extent possible, then looking to deploy remaining resources to the second highest risk adjusted return and so on.

The firms who had less losses in the crisis did not seek to maximize their risk adjusted return.

They did not maximize their participation in the opportunity with the highest risk adjusted return.  They spread their investments around with a variety of opportunities.  Some with the highest risk adjusted return choice and other amounts with lesser but usually acceptable return opportunities.

So when it came to pass that everyone found that their models were totally in error regarding the risk in that previously top opportunity, they were not so concentrated in that possibility.

They left something on the table and therefore had something left at the end of that round of the game.

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Explore posts in the same categories: Enterprise Risk Management, Risk, Risk and Light, Tail Risk, Unknown Risks

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4 Comments on “Leave Something on the Table”

  1. Krystal H Says:

    Hi there, we just published this blog post that references your post about Risk Management Success. I thought you might be interested in reading it. http://bit.ly/hmRxLg

  2. Max Rudolph Says:

    When I think of optimizing an investment opportunity, it is always within the context of leaving a margin of safety behind. This differs from the company that “optimizes” their capital allocation based on best estimate models and driving on/over the edge of the cliff. Stress testing can help with deterministic risk scenarios that assume several bad things happen at once. You will never fully insulate yourself from events you can’t control, but these methods will make blowups less likely. (one example is to buy stock in companies with low debt as a constraint within a normal optimization tool)

  3. riskviews Says:

    And every so often a bridge (I35W) collapses anyway. In addition, unfortunately some people seem to think that when there is 1/100 risk that they have just started taking that it works like an engineer who says that the bridge will last 100 years.

  4. jimlynch9999 Says:

    Reminds me of how structural engineers work. They precisely figure out how much stress an object needs to absorb, then they build the object 10x stronger. They assume they have made a mistake or the material may have a weak patch or the structure may not be assembled correctly. The 10x factor gives them a cushion.


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