The psychology behind financial risk calculations
Acuity canvasses three very different approaches to calculating financial risk and looks at the psychology behind decisions
- Ego can get in the way of calculating and managing financial risk
- It is never one event that causes catastrophe, but a combination of two or three things
- When it comes to the psychology of risk, people are too focused on the downside
By Ben Power
An actuary, a bookmaker and a chartered accountant walk into a bar. What would they talk about?
How they each calculate financial risk, of course.
They would all wax lyrical about their different approaches. But there are a number of things they would agree on.
Firstly, that calculating financial risk in this day and age is no joke. The business environment and financial markets have never been more uncertain, with low growth, high volatility and record low interest rates meaning both organisations and investors are all tempted to take on greater financial risk to boost returns.
They would also agree that calculating financial risk isn’t entirely a hard science. There is also art involved, and part of that art is borne of long years of experience.
And they would probably agree on a final point: that risk isn’t all downside — in making our decisions we need to consider the upside of financial risk as well.
Bookmaker: the art and science of making odds
Mark Stafford says bookmakers are different to actuaries.
“Actuaries don’t take as much risk as bookmakers do,” he says.
“We have to back a hunch.”
In the early 1990s Stafford was one of the first New Zealanders to jump on the sports betting trend. When he heard that the TAB was launching sports betting in New Zealand he applied for a job there, eventually landing a position with the TAB’s Quality Assurance division; 18 months later he moved to TAB’s sports betting bookmaking desk.
He has been calculating odds on sports events ever since, and has formulated a methodology for calculating and managing financial risk that combines deep research, risk parameters, instinct and psychological management.
In the mid-2000s a professor from Lincoln University in Christchurch spent a week with Stafford’s bookmaking team. He wanted to figure out how they came up with odds. Stafford asked the professor to give him a phantom game: it was the Wallabies versus All Blacks. Stafford asked where they were playing, whether it was a day or night match, and if it was fine or raining. Stafford shot his odds back: $1.30 for the All Blacks and $3.30 for Australia. “How did you do that?” the professor asked. “I don’t know, I just did it,” Stafford said.
Stafford says his method of calculating odds is “sort of a mathematical formula” but there is “a lot of instinct as well”.
Stafford’s first step is research. For the rugby season, for example, Stafford rates every single player and every single team out of ten. He includes other factors, such as home advantage and recent form, to create a total. In Super Rugby, The Hurricanes might be playing the Queensland Reds; the Hurricanes might total 145 and the Reds 125, so the Hurricanes have a 20-point advantage.
“That’s where I start,” Stafford says.
But to manage risk, Stafford also works within parameters for odds and losses. Stafford might be convinced that Queensland is going to win the State of Origin Rugby League, so he would have Queensland at $1.50 for a win, against NSW’s $2.50. But punters could flood to NSW because it offers value, so Stafford’s book could quickly amass a sizeable liability on NSW.
He might still be convinced Queensland is going to win but once he could potentially lose $50,000 on NSW, he’ll move the price on Queensland to say $1.65 and NSW to $2.15 in a bid to attract more money to Queensland to try and offset that liability.
Stafford says that ego can get in the way of calculating and managing financial risk. He remembers in 1998 when the country fell in love with the horse Just Call Me Sir. A bookmaker said the horse could never, ever win:
“He kept selling it and selling it and selling it.”
It became a national story — the public versus the bookmaker. Despite the bookie’s certainty he was dead wrong — the horse won.
“You have got to have confidence,” he says.
“But there comes a time when you have to know when to stop. You can have an opinion, but don’t always think it’s 100 per cent right.”
Actuary: financial risk over the long term
Wade Matterson, a Fellow of the Institute of Actuaries Australia and head of Milliman’s Australian Financial Risk Management Practice, says calculating financial risk is about promises that people and organisations have made, and how uncertainty affects the value of that promise in one way, shape or form.
But one of the most unique aspects of insurance is how long the insurer is exposed to financial risk. It could be periods of ten, 15 or even 30 years. An airline can hedge petrol price moves over 18 months by trading oil futures. But financial instruments don’t exist to hedge risk out 20 or 30 years.
“It’s very hard to go out and buy 20-year options on equity markets.”
Calculating long-term financial risk, therefore, “becomes a combination of art and science”.
“Actuaries are very good at coming up with approaches that can essentially bring together the short-term focus with long-term dynamics,” Matterson says. One solution is to offer modern-day retirement products that include features and “promises” to manage some of those risk. But ultimately calculating long-term financial risk needs extrapolation of short-term characteristics of the market into a longer-term horizon.
When confronting long-term uncertainty, experience matters. Matterson notes that many investors invest large amounts into fixed income style investments. The traditional view is that fixed income is relatively conservative and lowers a portfolio’s risk.
“But if you go back to ‘94 and what happened during the bond crisis, those sorts of decisions didn’t actually end up that well,” he says.
“Many people haven’t seen different events take place. I’m not saying it [a bond market crisis] is happening tomorrow but those are the things you have to think about.”
Matterson says “it’s the tails that really hurt you and cause the most pain and damage”, and there it is never one event that causes catastrophe, but a combination of two to three things.
A lot of Matterson’s work is helping organisations balance the downside and upside of taking financial risks.
“The world is full of optimists and pessimists. You need to find middle ground.”
But when calculating financial risk Matterson counsels slight caution.
“You win by not losing,” he says, adding the worst risk outcomes create the biggest issues.
“You’ve got to find ways to avoid absolutely dire outcomes. There might be a small cost to growth, but over the long term you end up in much better shape.”
The world is full of optimists and pessimists. You need to find middle ground.
Chartered accountant: a better way to calculate risk
Chartered accountant Rob Hogarth FCA and risk advisor Tony Pooley have spent their working lives around financial and operational risk. Hogarth spent 29 years as a partner at KPMG focusing on business risk. Pooley, originally an engineer, is a risk advisor to industry and founded Australia’s first quantitative risk consultancy.
But they were both still frustrated with how most businesses assessed and managed business risk. They were never comfortable with the qualitative risk assessments that 90% of organisations use. But boards like it because it produces a neat and visual risk matrix.
Hogarth says qualitative risk assessment creates a number of problems. He and Pooley found, for a start, that a risk can be 50 to 1,000 times greater than another risk in the same quadrant on the matrix, which leads to wasted resources managing risks that don’t really matter.
But the biggest problem is that qualitative risk assessment doesn’t deliver information that can be used by managers and boards to inform strategic decision making and decisions around risk appetite.
Hogarth and Pooley documented a quantitative risk management framework, which they’ve outlined in a book Risk Bandits: Rescuing Risk Management from Tokenism.
Hogarth says their method is a “pragmatic approach to quantitative risk”.
Basically, when using their method an organisation looks at the causes of each risk. How often do those causes occur? What’s the likelihood? In a warehouse, the potential causes of injury could be a falling box, a forklift incident or an overhead crane incident.
The qualitative method is quick: 20 risks can be assessed in a day. The quantitative method, however, takes at least a day for each risk. That forces organisations to prioritise risks.
“It’s the top three to four risks that really matter,” Hogarth says.
The quantitative method produces a risk value: the expected difference from planned EBIT. The exchange rate, for example, might fall ten cents and miss expected EBIT by $1m, which is the risk value. Hogarth says the process isn’t necessarily looking for “a whole lot of precision” or an exact number. But it’s “a much better estimate” than qualitative risk assessment.
Rather than a matrix, a board member would be handed a bar-chart of risk value estimates.
It also handles a range of consequences: there is a big difference between someone scratching themselves in a warehouse, and someone breaking a leg or dying.
But another major benefit of the quantitative method is that it considers both upside as well as downside risk. Hogarth notes that risk standards tell organisations to consider both.
“But very few do it because they can’t do it with the risk matrix.”
When it comes to the psychology of risk, Hogarth says people are too focused only on the downside. But the exchange rate might rise, creating upside.
“People are always dealing with hazards,” he says.
“They don’t use risk management to enhance opportunity.”
Ben Power is a freelance writer and communications consultant.
This article was first published in the July 2016 issue of Acuity magazine.