You need to know how much risk you’ve been taking first
Everyone struggles with choosing a risk appetite. But that is the first mistake. Risk appetite will not be singular. Risk Appetite is plural. It refers to any aspect of risk that goes beyond what you will comfortably accept.
In the paper Risk and Light, it mentions a number of aspects of risk:
- Type A Risk – Short Term Volatility of cash flows in 1 year
- Type B Risk – Short Term Tail Risk of cash flows in 1 year
- Type C Risk – Uncertainty Risk (also known as parameter risk)
- Type D Risk – Inexperience Risk relative to full multiple market cycles
- Type E Risk – Correlation to a top 10
- Type F Risk – Market value volatility in 1 year
- Type G Risk – Execution Risk regarding difficulty of controlling operational losses
- Type H Risk – Long Term Volatility of cash flows over 5 or more years
- Type J Risk – Long Term Tail Risk of cash flows over 5 years or more
- Type K Risk – Pricing Risk (cycle risk)
- Type L Risk – Market Liquidity Risk
- Type M Risk – Instability Risk regarding the degree that the risk parameters are stable
It is quite possible that a full risk appetite would could address each of these aspects of risk and more.
But a more difficult hurdle is the fact that in many cases risk exposure is not consciously known. In some cases, that is because of a confusion between RISK and LOSS. Some of that is because of the overuse of the word risk. In many situations, risk is used to mean an expected loss.
But for risk appetite, it is never the expected loss or even the actual losses that is of concern for a risk appetite. The risk that matters is the potential for future loss.
But to have any idea of how much risk that a person or a firm might be comfortable with, they need to have experience with risk. To have an articulate risk appetite, that experience must have been quantified.
How much was the risk exposure last year? How much was it the previous year?
And when we try to think of how much risk, we need to recognize that risk has many aspects that may need to be quantified. Risk is complicated. It does not reside in a single number.
Why would we think that it did? Try to name anything important that can be represented with a single number. Can you represent your car with a single number? Can you represent your brother with a single number? Can you represent a book with a single number? Risk is a potential for future loss, that potential has many more possibilities than an existing physical object. The object needs to represented by many different numbers.
But not all of the aspects of risk are ultimately important in most situations.
But before anyone or any business can form a risk appetite, they need to identify the characteristics of risk that are most important to them and then they need to build an experience base. They need to know how much risk that they have taken in the past. They need to know how much they can get paid for taking the risk. They need to know when they were at risk of having their lights put out.
Better to have this experience in real time. But second best is to work backwards into the past.
Faced with real information, matched up to real experience, then the stories of how to create a risk attitude will then start to make sense.
But up til then, it just won’t mean anything.