Like a child, I covered my eyes and hoped by not seeing my financial statement, the reality of my shrunken retirement reserve would magically not affect me. Shame on me--I advocate to boldly grab the reigns of risk and risk-based decisions. But when it came down to it, I personally tried to avoid it at all costs, steering clear of that sinking feeling.
After my financial adviser finished passing me tissues to wipe my tears, he asked, Maybe we should take this opportunity to revisit your risk appetite for your investment choices? Ok. I want stocks that make me plenty of money and I want to stay clear of those that don't. I waited for him to write that down, but strangely he looked back at me wide-eyed.
He flipped back to my original account planning document and told me that under the account risk tolerance clause I chose 50 percent high-risk investments. This in the small print means "customers are comfortable with investments which may fluctuate significantly in value and may result in the loss of a substantial portion, or all, of the invested capital." Well, I got what I wanted but clearly comfortable was not what I was feeling.
When someone says they have an appetite for risk, does that imply the person is outwardly seeking risk? Or do they mean the person will suffer risk if only suitably rewarded? Or do they mean something completely different?
Is there any jargon more confusing than terms like risk appetite, tolerance, position, philosophy, and acceptability? These can be dangerous linguistic traps reinforced by easily misinterpreted theories about risk. Was I victimized by a misconception captured in the capital asset pricing model of higher risks always translating to higher rewards? How else will I accumulate funds to allow me to lie belly-up on a tropical beach at age 55 if I don't take on riskier investments? I suspect many companies have also falleninto this trap and have paid the price. It feels like the perfect time to revisit how we measure our propensity for risk.
Specifying the importance of risk is critical. We need to define our risk appetite to try to influence how a collection of people make decisions on behalf of an organization in the face of risk and uncertainty. The key is the translation from theory to practice. As we see this "high, medium, low" model needs a little work.
In an attempt to find a more sophisticated method, I recently reviewed work in this area by Dr. James Kallman of Kallman Consulting Services. His method for determining corporate risk positions involves an advanced iterative approach that painlessly elicits from board and senior executives, individual philosophies, fears and dreams. This soul-searching process delivers vital consensus and tangibly articulates disparate views of corporate risk position.
He states, "A risk position is the combination of risk appetite and tolerance. Appetite is how big are your eyes while tolerance is how big is your stomach. The key to prudent decision making is the unambiguous understanding of the collective greediness of corporate eyes as well as the anatomy of the corporate stomach."
JOANNA MAKOMASKI, the former risk manager for a global energy company, is a leading specialist in innovative Enterprise Risk Management methods and implementation techniques for ERM Quickstart. She writes on risk management.
June 1, 2009
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