HOW DO WE MEASURE RISK? If you accept the argument that risk matters and that it affects how managers and investors make decisions, it follows logically that measuring risk is a critical first step towards managing it. In this chapter, we look at how risk measures have evolved over time, from a fatalistic acceptance of bad outcomes to probabilistic measures that allow us to begin getting a handle on risk, and the logical extension of these measures into insurance. We then consider how the advent and growth of markets for financial assets has influenced the development of risk measures. Finally, we build on modern portfolio theory to derive unique measures of risk and explain why they might be not in accordance with probabilistic risk measures.
Fate and Divine Providence Risk and uncertainty have been part and parcel of human activity since its beginnings, but they have not always been labeled as such. For much of recorded time, events with negative consequences were attributed to divine providence or to the supernatural. The responses to risk under these circumstances were prayer, sacrifice (often of innocents) and an acceptance of whatever fate meted out. If the Gods intervened on our behalf, we got positive outcomes and if they did not, we suffered; sacrifice, on the other hand, appeased the spirits that caused bad outcomes. No measure of risk was therefore considered necessary because everything that happened was pre-destined and driven by forces outside our control.
I have been involved in many risk management programs over the years and my observation is that there is too much time spent on devising risk models and agreeing on risk terminology as opposed to managing risks and opportunities. I actually do mini risk reviews in my head all the time now for both personal and professional situations and I find it pays huge dividends.
I have been involved in many risk management programs over the years and my observation is that there is too much time spent on devising risk models and agreeing on risk terminology as opposed to managing risks and opportunities. I actually do mini risk reviews in my head all the time now for both personal and professional situations and I find it pays huge dividends.
Risk management is a large part of my job, and I agree 100% with this. The other problem is that many risk models don't work well at the extremeties of the scales (e.g. low likelihood high consequence events).
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