Market Risk

Location: New YorkAuthor: Beaumont VanceDate: Thursday, September 13, 2007

One of my favorite sources of business wisdom comes from a Sufi sage named Nasurdin. Many of his stories are applicable to risk management, probably because he was fond of pointing out where people are most blind or foolish; we just happen to be blind and foolish when it comes to risk and uncertainty.


As I read through the parade of daily articles about the current subprime meltdown, each trying to be more hysterical than the last, I am reminded of one of these famous Sufi stories. While traveling down the road one day, Nasurdin ran into a man who was depressed. The man revealed that he had suffered a long string of bad luck and, as a result, had lost everything except for the belongings he was carrying in his bag. So Nasurdin, being something of a mischievous sage, stole the man's remaining belongings and ran away down the road.

A mile ahead, Nasurdin placed the bag he had just stolen in the middle of the road, and hid in the bushes. Some time later the destitute man whom Nasurdin had robbed came upon his bag and started jumping up and down for joy. "What luck! What fantastic luck" the man exclaimed at having recovered his lost goods. Nasurdin, watching from the bushes shook his head and said, "What it takes to make some people happy!"

We often focus on our current state of loss to determine our level of happiness. If we win $100, and then lose $50, we often are unhappy, perceiving a loss. But if we lose $100, and then get it back, we are happy, perceiving a gain. Our perception of loss or gain depends not on the net result, but on how we frame it. Kahneman and Tversky devoted a great deal of time and effort to detail how framing radically changes the way we make decisions involving risk.

They showed that very often what we decide depends far more on how we frame a problem than on the actual facts. When it comes to assessing risk and probabilities, we are often fools. The subprime meltdown is a case-in-the-making for this foolishness. Of the many articles I have read in different, well-respected publications, none makes any mention of the amount of money that has been made to date on the mortgage market. None note that billions of dollars have been earned over the past years prior to the current losses. It is a grave omission; by discussing only the current loss, divorced of any reference to related past gains, the net result of the business is thoroughly obfuscated. This matters immensely in how we react to the current losses.

If a company like Goldman Sachs has earned $100 billion on mortgage backed securities over the past 5 years (I am just making this up for argument's sake) , then is a current loss of $5 Billion truly significant? Well, it is if Goldman forgets about the $100 billion and takes a highly risk averse stance. Being overly risk averse can cause as much loss as being overly risk taking.
But there is far more at stake here. Already many banks, perceiving only the downside, are pulling back their capital. Their peers, sensing that this is the right thing to do are also pulling out capital. The current mind set is "psychotic " according to Tony Crescenzi, a broker on Wall Street. The virtual cessation in trading of commercial paper has threatened to arrest the short term borrowing upon which many businesses rely to conduct operations. The effect is that of a run on the bank. When capital dries up, the economy slows and everyone loses.

Taking risks is what business is all about. Taking risks means that there will most likely be losses. If one is fortunate enough to suffer a loss of $95 for every $100 made, the net effect is still a positive cash flow. But if one forgets the gains and makes decisions based only on the losses, money can't be made. One becomes like those who endured the Great Depression and kept all of their money hidden in their mattresses.

Risk aversion can be an appropriate response. But it depends on the facts. As past sages such as Nasurdin, Kahneman and Tversky have shown us, our position on risk is often based on emotion or self deception rather than realities. This is why it is so incredibly important that specialists in risk and uncertainty (not just mathematical models, but the concepts) must be involved in strategic decision making. I fear that if we are not there to bring some sanity and logic to decision making, we will continue to get irrational exuberance followed by runs on the bank. We don't have to live this way.