As we progress in learning about comprehensive and scientific ways to measure and manage risk, see if you can suggest how each of the objections to heat maps in this article can be overcome.
Need a definition that will allow us to measure and manage risk comprehensively and scientifically
Risks We Take — Another Category of Blogs
We are risk averse when taking risks
Risks We Face — This Category of Blogs
We are risk seeking when facing risks!
There are many definitions of risk that vary by specific application and situational context. The widely inconsistent and ambiguous use of the word is one of several current criticisms of the methods to manage risk.
Some of the more popular definitions:
Expected Loss due to an uncertain event
likelihood times impact of loss
- Knightean Uncertainty:
Knight defined risk as a measurable uncertainty. According to this definition, no consequence is required for an event to be a risk.
- Financial Risk
Risk concerns the expected value of one or more results (consequences) of one or more future events. Stated a bit differently, risk is an uncertain event that matters.
Technically, the value of those results (consequences) may be positive or negative.
However, general usage tends to focus only on potential harm that may arise from a future event.
The harm is a failure to achieve one or more objectives.
2) Knightean Uncertainty
Frank H. Knight (1885-1972) was a Professor of economics at the University of Chicago.
Knight tried to distinguish measurable uncertainty (probability distributions) from uncertainties that are not measured.
Loss is not a part of Knight’s definition.
According to Knight’s definition, someone who watching a roulette wheel at a casino without wagering any money is a risk. This definition is contrary to the notion that a risk is an uncertain event that matters.
more to come…
You may have been told that humans are risk averse, but that belief is no longer true.
Humans are loss averse:
a) The fight-or-flight response (also called hyperarousal, or the acute stress response) is a physiological reaction that occurs in response to a perceived harmful event, attack, or threat to survival.
b) It’s in our DNA. Our distant ancestors, when faced with a fight or flight situation – for example being attacked by a tiger while attacking a deer –chose to avoid the loss and fled. Many/most of those humans who chose to fight instead of flight did not survive to pass on their DNA.
c) Kahneman and Tversky’s Prospect Theory (for which Kahneman was awarded a Nobel prize) showed that to humans, losses loom larger than gains. This is reflected in the slope for losses of the typical value curves being greater than the slope for gains:
But we are not always risk averse!
We exhibit risk-aversion when taking risks
that is, when seeking gains. For example, most people would not gamble $100 or $1000 on a flip of a coin — double or nothing.
But we exhibit risk-seeking behavior when facing risks
that is when faced with losses. For example, when facing a certain loss of $100 or $1000, most people would gamble double or nothing on the flip of a coin.
Humans are loss averse, but not necessarily risk averse.
When taking risks, humans are generally risk averse.
But when facing risks, humans are generally risk seeking. We have a natural tendency to gamble that risk events will not occur rather than invest in controls to reduce the risks.