Excessive risk: What is it? How do we measure it?

Interesting questions for two reasons. There are no good answers. Yet this doesn’t deter many government leaders and policy makers from pontificating on the subject and dreaming up all types of initiatives to prevent “excessive risk taking”.

So what is excessive risk? Can/should it be measured by the probability of failure? If so, what is too high a failure rate? A 100% failure rate is obvious (except in the world of Max Bialystock). But who is stupid enough to make an investment that is certain to fail? Ah yes, the ponzi schemes and the greedy and stupid investors in such schemes. Then there are the government sponsored lotteries.

How about a 95% failure rate, or a 90% rate? What if the expected value of an investment with such high failure rates is positive? Economic and finance theory make it clear that such value enhancing investments should be made.

Venture capitalists are pleased when the failure rates of their investments do not exceed 30%. So what is the cut-off point? No one knows!

A failure does not necessarily lead to a complete loss. Some of the initial investment might be recovered. In some cases (e.g. investments in R&D), even the prospect of a very high failure rate should not block the investment since this might be the price to pay to continue in the game. A failure provides useful information, and making the investment might help create the research, design or marketing infrastructure necessary for future success.

More importantly, decisions are always made with incomplete and imperfect information. This is the essence of risk taking. There is no certainty other than the decision might prove to be wrong. So how can we determine with any degree of precision the probability of failure at the time a decision is made?

The rocket scientists on Wall Street believed they could. But they learned, or hopefully they have learned, as we all did, that their models are predicated on the past repeating itself and a number of assumptions, some or all of which could be wrong. Intuitively, we can assign probabilities of success and failure to various scenarios, and base our decisions on some expected value measure. But only time will tell if we were right or wrong. This is why contingency planning, a seemingly lost art in many companies, is important. Thus, how is any government ever going to decide what is excessive risk taking?

Finally, what if a government passes and enforces legislation aimed at making the senior management running domestic companies risk averse? That is, no one might be allowed to make a decision with an expected failure rate of 5% (ignoring how we would even determine the potential failure rate). Not taking risks, even supposedly excessive ones, might prove to be the most risky strategy. The world does not stand still. Competitors elsewhere might still engage in what Josef Schumpeter called “creative destruction”. They might gain an advantage and become the dominant players in their sectors, marginalizing or even driving out those who became or were mandated to become risk averse.

Good luck to the bureaucrats going down the path of trying to banish excessive risk taking. Common sense tells me that they will fail!