Risk Managers
Taleb describes a conflict facing institutional risk managers: stopping a profitable trade can attract blame for lost gains, while allowing it can attract blame for a later collapse. He argues that these incentives can encourage vague warnings and self-protection.
THE IDEA
Corporations and financial institutions have created the strange position of risk manager, someone who is supposed to monitor the institution and verify that it is not too deeply involved in the business of playing Russian roulette. Clearly, having been burned a few times, the incentive is there to have someone take a look at the generator, the roulette that produces the profits and losses. Although it is more fun to trade, many extremely smart people among my friends (including Jean-Patrice) felt attracted by such positions. It is an important and attractive fact that the average risk manager earns more than the average trader (particularly when we take into account the number of traders thrown out of the business: While a ten-year survival rate for a trader is in the single digits, that of a risk manager is close to 100%). “Traders come and go; risk managers are here to stay.” I keep thinking of taking such a position both on economic grounds (as it is probabilistically more profitable) and because the job offers more intellectual content than the one consisting in just buying and selling, and allows one to integrate research and execution. Finally, a risk manager’s blood has smaller quantities of the harmful kind of stress hormones. But something has held me back, aside from the irrationality of wanting the pains and entertainment from the emotions of speculation. The risk managers’ job feels strange: As we said, the generator of reality is not observable. They are limited in their power to stop profitable traders from taking risks, given that they would, ex post, be accused by the George Wills around of costing the shareholder some precious opportunity shekels. On the other hand, the occurrence of a blowup would cause them to be responsible for it. What to do in such circumstances?
Their focus becomes to play politics, cover themselves by issuing vaguely phrased internal memoranda that warn against risk-taking activities yet stop short of completely condemning it, lest they lose their job. Like a doctor torn between the two types of errors, the false positive (telling the patient he has cancer when in fact he does not) and the false negative (telling the patient he is healthy when in fact he has cancer), they need to balance their existence with the fact that they inherently need some margin of error in their business.
When to use it
A financial institution evaluating whether to approve a high-risk loan that could yield significant profits but also poses a default threat.
A pharmaceutical company deciding whether to halt a drug trial due to observed side effects, balancing patient safety against the cost of lost research investment.
A safety inspector in a manufacturing plant deciding whether to shut down a production line for a potential defect, weighing the cost of downtime against the risk of an accident.
An investment manager choosing between a conservative portfolio and an aggressive one with higher potential returns but greater chance of large losses.
FROM THEORY TO EVERYDAY LIFE
In practice
Risk Manager vs. Profitable Trader
A risk manager at a hedge fund observes a trader who has been consistently generating high returns through aggressive strategies. The risk manager suspects the trader is taking excessive risk that could lead to a large loss, but any intervention to limit the trader's activities could be seen as costing the fund potential profits. The risk manager issues a vague memo warning about risk-taking in general, without specifically targeting the trader, to avoid being blamed if the trader succeeds or fails.
Medical Diagnostic Analogy
A doctor faces a similar dilemma: falsely diagnosing a healthy patient with cancer (false positive) causes unnecessary stress and treatment, while missing a real cancer (false negative) could lead to death. The doctor must balance these errors, just as a risk manager must balance warnings against risks with not stifling profitable opportunities.
A MOMENT TO REFLECT
Put it to work.
How can a risk manager effectively communicate risk warnings without being accused of costing the organization profitable opportunities?
In what ways do the twin errors of false positives and false negatives apply to your own decision-making in risk assessment?
What political dynamics might influence a risk manager's actual behavior versus their stated duties?
CONTINUE THE CONVERSATION
Source texts
- Fooled by Randomness The Hidden Role of Chance in the Markets and in Life (Nassim Nicholas Taleb)