By Brett Sherman, The Sherman Law Firm
What the heck is risk? It is hard to get the same definition from two dictionaries. It can be even harder to elicit agreement between two economists. Forget about any uniformity among financial institutions on the meaning of risk. This, we submit, is a pretty big problem for an industry in need of significantly improved risk management systems.
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Here is a nice compact definition of risk: "Risk equals the inherent chance of a bad result from a decision or course of action."
but...
Here is a bit more, umm, comprehensive definition: "Risk is a foreseeable possibility that an uncertain future will produce an unexpected negative outcome. The more risk a given action carries, the greater the chance for unexpected negative consequences."
and then...
The basic, cut to the chase definition... "Risk equals chance of loss."
One Supreme Court scholar even said this: "I can't define risk, but I know it when I see it." Maybe not.
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There are plenty of other variations on the meaning of risk floating around the financial universe, and the differences aren't always subtle.
The most notable dispute regarding the definition of risk has to do with the relaionshio between risk and uncertainty. Some "experts" insist that risk and uncertainty are inseparable. They claim that the very nature of risk stems from the fact that outcomes are uncertain (i.e., that we can't predict the futre). This makes sense to us at the WSLB.
HOWEVER, other "experts" claim that risk and uncertainty are totally distinct concepts. The idea is that risk allegedly can be measured, while uncertainty cannot. This position, which is surprisingly popular, feels wrong to us. True, some risks can be measured (a good example being gambling odds), but even measurable risks seem to require large samples before statistical probabilities outweigh random chance.
For example, you can flip a coin 30 times and very easily wind up with heads 21 times. If you flip the coin 100 times, the results will probably be closer to even. If you flip it 1000 times (this is a thought experiment, we don't have the patience for 1000 coin flips) then the probability of an outcome close to 50 percent heads / 50 percent tales is even more likely.
At least to the lawyers here (if we were good at math, we would have been doctors), it seems more logical to include uncertainty in the definition of risk. Separating the two concepts is counterintuitive, and it implies that statistical probability is an effective way to measure risk in finance. If risk could be measured with anything close to precision, quants would be a lot more popular today, no?
In any event, the crucial point here is that the term risk management is thrown around an awful lot these days. To define risk management, and practice it effectively, it might be helpful to make agreement on the meaning of "risk" itself a priority.
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