Research Foundation Briefs 5 October 2020
Learning about Risk Management: Insights from Unconventional Risk-Takers
Think financial professionals have a corner on risk management? Think again. Learn how a Hollywood movie mogul, a poker champion, and a big wave surfer can offer key lessons in risk management, risk mitigation, and client communication.
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A global pandemic forced everyone to live with more risk. We had to deal with more volatile markets, and even going to the grocery store required some risk management. Suddenly, everyone became more aware of what a risky place the world can be and that life requires deciding what risks to take and how to manage them. Most people were unprepared for the new risks the pandemic posed, in large part because we don’t have good tools to help people make sense of risk.
If you work in finance, these problems are more familiar because risk management is our job. Risk in finance means the possibility for higher return, the chance to get more for less. Or, if you are uncomfortable with risk, you can pay to reduce it. Deciding how much risk to take and how much to reduce it are things we do every day.
The pandemic shows that everyone—not just financial professionals—must manage risk. Whether in jobs, retirement portfolios, or daily tasks, we all have to make decisions when faced with uncertainty. Financial professionals often complain people can’t understand risk, but perhaps risk is not explained clearly or in ways that make sense to non-financial professionals. It is no wonder most people struggle.
As financial professionals, part of our job is to communicate risk to clients. This is an important skill, as important as risk management. But we don’t have many tools to explain risk in ways that are meaningful. One valuable tool we can use, however, is storytelling.
Storytelling is a valuable way to communicate complex ideas. Everyone connects to stories about people. A financial model is in many ways a parable, an abstraction of the world that offers insight into important lessons and relationships. We can use parables to better communicate financial risk. This brief is a collection of such parables.
This brief shares stories of people in industries that may appear to have nothing to do with finance but where risk measurement and management are also crucial for success. I first describe the challenges of risk measurement in the movie industry, where a heavily skewed distribution of payoffs and an ever-changing market make estimating risk extremely difficult. These challenges with risk measurement leave Hollywood film studios largely in the dark about which movies will be successful. When you can’t measure risk, managing it is nearly impossible; this explains why Hollywood makes the movies it does. The new economics of movies, however, means more data are available that could lead to better estimates… and maybe to better films too.
The next story is about poker champion Phil Hellmuth. Hellmuth is one of the world’s best players, and he is also among the most patient. He only plays 12% of his hands, a much lower percentage than average. This reserve is all the more remarkable because he is also known for being a volatile personality who throws tantrums when he loses. We all have behavioral biases that undermine making good risk choices. We tend to be impulsive and are willing to take big risks to avoid losses. But Hellmuth is an interesting case because, on the one hand, he is known for losing control; on the other hand, he is one of the industry’s most disciplined players. He shows we can overcome our biases when it matters. And he explains how he does it.
The third story takes us to the North Shore of Oahu, Hawaii, to the Big Wave Risk Assessment Group’s annual summit, a risk conference for big wave surfers. It turns out big wave surfers face many of the same issues financial professionals do: Surfing big waves is all about risk management. The surfers’ risk choices affect not only themselves but also others. Some surfers, often aided by a new technology, try to ride waves above their skill level, but when they do that, they can pose harm to other surfers. Helping surfers account for how their risk choices impact others remains a challenge, just like it does for people who work in financial services.
Also a central issue during the pandemic, this chain of influence highlights the role that government regulation is supposed to shoulder, helping us internalize the cost of the externalities we create. Government regulation also poses trade-offs because it can infringe on liberties and curb valuable risk taking. The surfers don’t want government regulation in their sport; they prefer to leave it to individuals to behave responsibly. But often this choice is ineffective because everyone has different risk preferences.
The stories in this brief highlight the same issues financial professionals face every day. The lessons found not only offer examples of how to communicate risks to clients, but they also help us become better risk managers. Often, seeing what we do every day in a new context deepens our understanding of it. We can see new subtleties. This knowledge helps us to better use existing tools and also to develop new ones.
The value of risk reduction is often underestimated outside of finance. This miscommunication poses a challenge when it comes to dealing with clients, and it is one reason why many people question the value of financial services. The novel coronavirus reminded the world how valuable risk management can be and how important it is to communicate risk in a way people find meaningful. Going forward, financial professionals must do more to communicate the principles of risk management.
About the Author
Allison Schrager is a senior fellow at the Manhattan Institute and co-founder of LifeCycle Finance Partners, LLC, a risk advisory firm.
Before joining the Manhattan Institute, she worked in finance, policy, and media. She led retirement product innovation at Dimensional Fund Advisors and consulted for international organizations, including the OECD.
She was a staff writer at Quartz and has been a regular contributor to the Economist, Reuters, and Bloomberg Businessweek. Her writing has also appeared in the New York Times, the Wall Street Journal, Playboy, Wired, National Review, Foreign Policy, and Foreign Affairs. She has an undergraduate degree from the University of Edinburgh and a PhD in economics from Columbia University, where her research focused on labor markets and retirement finance. She lives in New York City.