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Views from the Prairie

January 13

Simple and Complex Risks

We humans are used to simple risks. However, sometimes, a simple risk changes into a complex risk. Two of the common complex risks are "Compound Risk" and "Connected Risks". Humans have a hard time identifying when a perceived simple risk has modified into a complex risk. The rules we learned about simple risks do not apply with complex risks.

We learned about risks first in school and sports. With these simple risks, we learn two rules about risks: the more we do something, the less the risk to us; and as the number of people doing it increases, the less the risk to us.

Compound risks are not like that at all. For example, few people have harm from their first puff of marijuana or tobacco or their first drunk. But there are effects that build up and the risks increase the more we do these activities. Environmental effects are another arena with compound risks.

In business, compound risks are often found in connection with ethics issues. When we take an ethical risk and have no consequences, we are likely to take more and more ethical risks. Yet, as we take more ethical risks, society works harder to give us consequences. Suddenly, the business person is being arrested and wondering how they got to that point.

Connected risks are the risks that depend on each other. The traditional way to evaluate risks has been to consider each one independently. However, a number of risks actually depend on each other.

Again, ethics are one area where risks often are connected. For example, if one professional athlete is using performance enhancing drugs, that generally can be detected and that person punished. But when a whole sport is filled with people using, nearly everyone will get smeared when the technology for detecting such gets better.

Connected risks get worse as the number of people doing them increase.

In business, there have been a number of cases where a number of simple risks became a connected risk. Businesses would expand and assume that they are taking on simple risks only to find out later that by expanding, the risks had connected together. This is not easy to spot as there isn't a clear "tipping point" where simple risks connect up.

The most recent example of this occurred in the 2008 financial meltdown. The risks of each mortgage going bad were all evaluated independently as simple risks not realizing that by so many people taking the same risk at the same time, the risks were being connected.

Other examples have happened when a previously small company expanded so much that it was now a dominant force in the market. Practices that were tolerated by a small company are not acceptable by a dominant company. IBM, Microsoft, and Google have all found themselves in this position.

Connected and Compound Risks can cause real problems.

Investments and Rarity and Risk

All investment strategies are dependent on the fact that not everyone is doing that strategy. This rarity includes bank savings accounts. Not everybody has one. The percentage of people saving money is quite low.

When everybody is doing something, we pay for the privilege. When everybody is saving money in a bank, the bank does not pay interest; we pay the bank for the privilege of letting the bank hold our money.

When everyone is doing an "investment", the risks of that investment have changed from simple risks to connected risks. Connected risks mean that when something goes wrong, it generally hits everyone at the same time. That means that the "investment" is actually a bubble.

Checking to see how many people are investing in something is an important part of the investment evaluation. When nobody is investing, there is often a good reason. When everybody is investing, it means that it will not be a good investment. Thus, when everybody wanted to get in on the Facebook stock, it was not a good investment.

Similarly, the current wave of "algorithm trading" is starting to take on connected risks. When only a few places were doing that kind of trading, it was highly profitable and did not pose significant risks to the system. Today, when a large percentage of all trades are algorithm trades, there are risks we don't know about yet. The "flash crash" is but one example.

There is no one way to evaluate if too many people are involved in an investment or if too many people are taking the same risk. Yet, making that judgment is one of the key parts of proper investment management.

Risky World

The IBM computer system that played Jeopardy, Watson, was briefly taught the "Urban Dictionary" as a way to try to make it speak more like a human being. Unfortunately, it learned the worst way: that of an unrestricted teenager. The makers of Watson have taken the "Urban Dictionary" out of it and added a "swear filter" so that even the language found in Wikipedia won't cause problems anymore.


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