Most tell me that this is a simple process. They simply meet with members of senior management and/or the board of directors and ask, "How much are you willing to lose in a quarter?"
Sometimes they dress up this process with some graphs and a bit more detail, such as measuring the loss in share price or revenue or some such.
This method of creating a risk threshold is a scourge! It is dangerous. It confuses and infuriates executives and it is dead wrong. Why? Imagine that you take a trip to Las Vegas. When entering the first casino, an employee meets you at the door and asks, "How much are you willing to lose?"
It is possible to answer the question. You could calculate how much money you are worth and take a percentage or some other similar calculation. But this question doesn't provide useful information regarding how you will make decisions regarding the various wagers inside of the casino.
It is unlikely that you are going to make bets based on your net worth, value of future cash flows or credit worthiness; in order to place reasonable bets, you will need to know the amount you stand to lose, the amount you could win, as well as the odds.
No responsible person would make bets based solely on a total loss amount. Let's say, for example, that you decided on $10,000 as the sum you could lose. Would that amount change if I told you that you were going to be playing a game where you had to bet the entire $10,000 all at once with odds of 1,000,000 to one against you winning, and with a total maximum payout of $500? Only a fool would take that bet.
However, you might be willing to risk $1 on 1,000,000-to-one odds if the payout was $10 million. You also might be willing to bet $10,000 over 20 bets with an 80 percent chance of winning $20,000 on each individual bet.
Loss is only one part of the risk picture. The potential for gain and the odds of a gain versus a loss are critical to any decision involving risk. Any so-called risk appetite that fails to contemplate all of these elements by its very design is worthless. Executives who are accustomed to weighing loss, gain and probability are not likely to answer such a simpleminded question as, "How much can you lose?"
Risk appetite is important to an organization because the bets are perceived differently by senior management than by lower-level employees. For example, the CEO might be looking across the whole organization and seeing one hundred $1 million bets, each with a 60 percent chance of gaining $2 million and a 40 percent chance of losing $500,000.
A good CEO would want to take a lot of these bets because, on the whole, the company will come out ahead. However, a lower-level manager who is responsible for only one of those bets might not be able to withstand a $2 million loss. If the top-level risk appetite is not communicated effectively, very few of these bets will be taken in spite of the CEO's desire to do so.
I am reminded of this simple, yet often overlooked, point by a presentation recently given by Dr.Carl Spetzler of Stanford University. While the proper way to get to an appropriate and complete risk appetite is a bit too involved to outline here (though it will soon be in The Riskipedia at www.TheRiskipedia.com), it is of vital importance that we eliminate the simpleminded risk-appetite scourge before it does any more damage to our profession.
BEAUMONT VANCE manages risk for Sun Microsystems Inc. This column was a complimentary excerpt from one of his latest "Risk Management Reports" newsletters, which he edits and publishes. For more information on how to subscribe to the full version of the newsletter, please visit www.riskreports.com/
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February 7, 2008
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