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Understanding Risk

February 16, 2012 by
Filed under: General, Risk Management

There is a fundamental truth about risk, if you don't understand it, stay away from it. This is true when you try to repair the washing machine. Ask the repair man when you're afraid of being electrocuted. Same when you finance your house, if the mortgage construct is so complex you don't understand it, stay away. Same in business, if contracts are so complex you don't understand them, stay away. Similarly, when it looks too good to be true, it probably is. This too good to be true rule is actually the same as the understanding rule, because when it's too good to be true, you probably don't understand it.

The challenge is of course we don't know what we don't know. Consequently, we also don't necessarily know that it's too good to be true when we actually believe it is good. I know this for a fact, because I have ample experience with buying classic cars, overexcitedly.

This is related to the ability of people to assess risks. Risks further in the future are generally assessed lower than reality, whereas closer risks are assessed higher. This effect is evolutionary and beneficial. The effect enables entrepreneurs to think they have a great idea that will make them rich overnight, while it doesn't tell them all the horror they will face. On the shorter term, the effect also stimulates running away from scary tigers when they come too close. A risk manager should know all this, and should help dampen the effect. Help understand the risks and know when it's too good to be true. And be especially wary when the positive effect is far in the future, because then we tend to be too rosy. If only I knew all of this when I bought that Riley several years ago. Since I sold it, it has continued its devastating path throughout Europe; the effect seems to be omni-present!

Tags: Risk, Risk Management, Enteprise Risk Management

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