September 7, 2017

6 mistakes people make in risk management... excellent read for traders

1. We think we can manage risk by predicting extreme events.

This is the worst error we make, for a couple of reasons. One, we have an abysmal record of predicting Black Swan events. Two, by focusing our attention on a few extreme scenarios, we neglect other possibilities. In the process, we become more vulnerable.

It’s more effective to focus on the consequences—that is, to evaluate the possible impact of extreme events. Realizing this, energy companies have finally shifted from predicting when accidents in nuclear plants might happen to preparing for the eventualities. In the same way, try to gauge how your company will be affected, compared with competitors, by dramatic changes in the environment. Will a small but unexpected fall in demand or supply affect your company a great deal? If so, it won’t be able to withstand sharp drops in orders, sudden rises in inventory, and so on.


2. We are convinced that studying the past will help us manage risk.

Risk managers mistakenly use hindsight as foresight. Alas, our research shows that past events don’t bear any relation to future shocks. World War I, the attacks of September 11, 2001—major events like those didn’t have predecessors. The same is true of price changes. Until the late 1980s, the worst decline in stock prices in a single day had been around 10%. Yet prices tumbled by 23% on October 19, 1987. Why then would anyone have expected a meltdown after that to be only as little as 23%? History fools many.

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