The Achilles' Heel of Risk Management

June 2008 - Bonus Resource

By Diana Del Bel Belluz, M.A.Sc., P.Eng.

Would you agree that house prices can only go up? In the present credit crunch era, that seems like a whopper of an assumption. But in the months and years leading up to last August’s sub-prime mortgage meltdown, it was a widely held assumption shared by homebuyers, lenders, investors, and regulators.

In a New York Times article titledWhat Happens If We’re Wrong?, author Peter L. Bernstein reminds us that forecasts are wrong from time to time, particularly when the underlying assumptions are faulty. (Click here to read the full article).

Bernstein warns that when managers ignore the true definition of risk, they lose all power to actually manage risk. He shares a simple definition of risk by Elroy Dimson of the London Business School, i.e., “more things can happen than will happen”. Bernstein explains that “if more things can happen than will happen, we can devise probabilities of possible outcomes, but -- and this is a big “but” -- we will never know in advance the true range of outcomes we may face”.

Bernstein pillories the assumption that home prices can only go up. He states that in this assumption “the word ‘only’ is ridiculous ... More things can happen than will happen. Under those conditions, risk management should concentrate either on limiting the size of the bet or on finding ways to hedge the bet so you are not wiped out if you take the wrong side -- if home prices do start to go down, or even stop rising.”

He concludes with this advice, “Effective Risk Management starts with the recognition that any forecast can be wrong, then weighs the consequences of being wrong. Only then can we decide whether to make a bet, whether to hedge that bet and how to execute the hedge if needed.”

In my view, assumptions are the Achilles’ Heel of risk management. We cannot avoid making assumptions. They underlie every decision and action we take. Therefore, if we want effective risk management, we need to learn how to handle assumptions properly.

Here are three simple strategies to deal with them:

  1. Recognize your assumptions for what they are, i.e., assumptions, not facts. We know now that ‘house prices can only go up’ is an assumption.
  2. Document your assumptions to demonstrate due diligence.
  3. Test your assumptions – both when you first make them, and then again from time to time.Validate your assumptions when conditions change.

I recently heard a hospital administrator share lessons learned from a minor fire that shut down a major health care facility for nearly a year. As a result of the fire, they discovered that many of their pre-crisis assumptions were wrong and routinely went unchallenged.

For example, they thought they’d be able to return to the building within hours of extinguishing the fire; but it was uninhabitable. Since the crisis, members of the leadership team engage in frank discussions about the assumptions that underpin their decisions.

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Do decision-makers in your organization identify and test their assumptions? Or is it just a matter of time until a crisis reveals your Achilles’ Heel?

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Diana's Pick

The Neuroscience of Enterprise Risk Management (written by Diana Del Bel Belluz of Risk Wise) expores findings from the field of neuroscience and shares practical tips on how to apply them to enhance individuals' risk management thinking and implement brain-friendly ERM practices in organizations.

The article was published by The Conference Board of Canada in the Autumn 2017 issue of the journal Risk Watch.