Key Messages
How To Overcome Flaws In Risk Assessment And Management: Exploring The Science Behind Weather Forecasts, Expert Opinions, Monte Carlo Simulations And More
When it comes to making decisions about risk, the accuracy of your results can be the difference between success and failure.
But many of the methods used to manage risk have inherent flaws that can lead to missed opportunities or even disastrous outcomes.
From relying too heavily on expert opinions, to not considering events that could happen but never have before, common risk management models often fall short.
But there is hope.
In this section, you’ll discover why many of the common methods for assessing and managing risk are flawed and what we can do about them.
From exploring the complexities of forecasting using Monte Carlo simulations, to understanding how you can mitigate risks with data-driven models, you’ll come away with a toolbox full of helpful tips and advice.
With the right knowledge, you’ll be able to make better decisions when it comes to evaluating and managing risk – no matter what kind of situation arises.
Risk Management: Understanding Probability, Magnitude And How To Get The Most Out Of Limited Resources
Risk management means being smart about taking chances.
It’s about identifying potential risks and actively working towards mitigating or eliminating them in order to help ensure success.
With risk management, organizations and governments have devised strategies to help better manage the uncertainty that looms over any endeavor – whether it be a natural disaster, a major product recall, political instability or otherwise.
To do this, they use what they have available: resources like money, time and personnel.
With careful planning and efficient coordination of resources, they can lessen probability and magnitude of an undesired event – whether that be financial loss or loss of lives – while still aiming to pursue their objectives.
In other words, risk management is an attempt to use limited resources to the best possible advantage by reducing danger, thus enabling success with calculated risks.
The Evolution Of Organizational Risk Management: How Did We Get Here?
Organizations around the world are recognizing the great importance of risk management.
Its history can be traced back to kings and leaders fortifying their cities, or storing reserves against tough winters.
But with the advancement of computers, a new path was opened up for Risk Management.
In the 1940’s, the increasing risk of nuclear power and oil exploration necessitated more sophisticated risk management methods.
This eventually led to breakthroughs such as during World War II and Cold War where “war quants” – primarily engineers and economists – used quantitative calculations for various purposes like gauging enemy production capabilities or estimating likelihood of invasion.
Today it isn’t just governments and militaries that utilize Risk Management, but businesses as well have started relying on it.
In 2007, three studies conducted separately by The Economist, Aon Corporation, an insurance broker, and Protivity, a risk management consulting firm surveyed more than 320 organizations spread across 29 countries about the role of risks and risk management – with fascinating results.
These surveys found that 95% of companies surveyed had hired or planned to hire a CRO (Chief Risk Officer) while 88% had measures in place to actively review their risk management systems at board-level meetings.
This only goes to demonstrate how widely recognized is the invaluable nature of Risk Management amongst businesses globally today.
It Is Clear That Risk Management Is Essential, But The Most Traditional Approaches Used Can Be Problematic
It’s clear that risk management is essential, but popular risk assessment methods are fundamentally flawed.
To start, the language used in these assessments can vary greatly in interpretation.
For example, how likely an event will occur if it is labeled as a “level 5” of impact? This leaves too much room for unreliable assumptions to be made.
To show this, the author asked a client who had recently attended a risk-assessment session what they felt “very likely” meant, which led to a disagreement between colleagues due to different interpretations.
These methods also don’t take into account relationships between risks or common mode risks that can increase the chances of events occurring together.
An example of this would be having three separate hydraulic systems installed in one plane where all three could fail simultaneously – not because there’s three chances for failure but due to a single potential action triggered by something like shrapnel from a broken propeller cutting all three at once.
Lastly, reliance on expert opinions alone can lead to inaccurate estimations and predictions of risks that may go unrealized.
Ultimately, the most popular risk assessment methods leave too much room for error and do not offer reliable and consistent results.
Experts Can’T Be Relyed On To Accurately Assess Risk Due To Biased Memory, Overconfidence And Inflated Self-Awareness
The idea of relying on expert opinion in order to manage risk has long been accepted without further scrutiny.
However, research shows that humans have a way of overestimating their own competence, and experts are no exception.
As evidenced by the study showing that 87 percent of Stanford MBA students ranked themselves in the top half of their class and the fact that most people inaccurately see themselves as better-than-average drivers, experts can be overly confident in their predictions and thereby underestimate risks.
On top of that, we also carry our own bias when it comes to recollecting information from experience.
Our memories are not perfect and can be influenced by things like the peak end rule which suggests our memories tend to focus on extreme or recent experiences more than others.
For example, if a picnic went wrong when there was only a 5% chance for rain predicted, you might jump to the conclusion that weather prediction is faulty even though it could have been right many other times.
All this just goes to show that expert opinions may not always be accurate or reliable when evaluating risk.
Calibration Training: A Reliable Way To Improve Expert Opinion In Risk Assessment
Calibration training is a valuable tool for improving the accuracy of probability estimations.
It reduces the potential for overconfidence, which often leads to inaccurate predictions.
This type of training involves repetition and feedback in order to hone one’s sense of uncertainty.
One simple way to use calibration training to improve probability estimation is by doing range testing.
With this method, questions like “What was the dollar price for a ton steel a year ago?” are asked, and the testee response with lower-end and upper-end estimates.
Through this process, they gain perspective on their confidence levels in their estimates.
The post-mortem analysis is another effective method of calibration training.
Here, the testee imagines that an event has already occurred and then considers its possible causes.
Going through this exercise can help elicit creativity regarding potential risks that may not have been noticed during brainstorming sessions alone.
Overall, calibration training can lead to better predictions by helping reduce overconfidence in personnel providing expert advice or a quantitative approach when assessing risk management issues.
Learn How Monte Carlo Simulations Help Us Assess Risk
If you’re looking for the most accurate way to estimate your risks, Monte Carlo Simulation is the best option.
It’s been used for some of the world’s biggest risks, from nuclear power safety to oil exploration and even environmental policies.
Monte Carlo Simulation looks at all of the variables associated with a risk and processes data to create models that analyze potential outcomes.
For example, if you wanted to invest $1.5 million in a new factory, you’d need to evaluate things like production capacity, selling price of wrenches, and expected demand.
The Monte Carlo Simulation would construct 10,000 or more scenarios using these variables- exploring every possible outcome- so you could emerge with an accurate evaluation of how much money you can make in each situation.
It’s important to note that Monte Carlo Simulations take into account complexly correlated variables- things like demand and price correlations- which can further enhance accuracy when estimating your risks.
So if you really want the most reliable result possible when evaluating finances or any other risky activity, consider using the powerful tool of Monte Carlo Simulation!
Uncovering Hidden Risks With Deconstruction: How To Simulate Events Without Any Data
People tend to think that if there isn’t enough data, using quantitative probability methods for risk management like Monte Carlo simulations is impossible.
They may be right in some cases, but that doesn’t mean you always have to rely on soft methods such as scoring or expert opinion.
It’s true that the data necessary for a successful simulation of events might not be available, but that doesn’t mean it can’t be attained.
One of the best ways is by looking at all the individual components of an object and computing the failure rate of each one.
Even if a disaster hasn’t happened before, chances are you’re going to find plenty of research and empirical studies on separate parts and materials used in it – which can give you an idea of what could happen.
Using this deconstruction technique produces a lot of meaningful data which gives us insight into why something hasn’t happened yet and provides information about what kind of risks we should watch out for in the future.
With such data at our disposal, we can then go ahead and compute the probability and magnitudes of disasters through Monte Carlo simulations with confidence!
So don’t let a seeming lack of data stop you from taking your risk management seriously – do your research carefully and break down everything into small pieces to get more accurate results!
The Value Of Knowing: How To Ensure Your Risk Analysis Is Accurate And Worthwhile
For those looking to ensure the accuracy of their probability assessment, it’s helpful to understand that the best way to test for flaws in your model is by comparing your estimates with facts on the ground.
By doing this, you might naturally identify missing variables or other critical uncertainties that have not been taken into account.
But what if you want to know whether it’s worth conducting a risk analysis for your organization? To answer this question, you’ll need to calculate the value of additional information.
Basically, that means finding out how much money you can save by mitigating risk—because in a business context, lower risks mean more cost savings.
The author suggests determining your expected opportunity loss first: take the probability of losing money multiplied by how much you’d lose.
Let’s say that comes out at $60,000; now we know how much is reasonable to spend on data and probabilistic tools that will back up our investment.
In conclusion, when anticipating an uncertain outcome and wanting to be sure of success, it pays off immensely to compare models with real-world facts and do math on what additional information would be worth for our venture.
Overcome Risk-Management Barriers With A Unified Department And Standardized Process
No matter how good your risk management tools are, it’s still going to be a challenge to manage risk if your organization doesn’t practice comprehensive risk analysis and management.
That means that you need a comprehensive organizational strategy and dedicated department devoted to assessing and monitoring risks across different departments, identifying key stakeholders, and standardizing the process for analyzing risk based on empirical data.
Such a strategy enables managers to better identify potential risks from major decisions, such as constructing a new production facility, which may have implications for multiple departments.
Additionally, by keeping track of the relationships between different risks and having access to a scenario library with set variables and correlations, organizations can use this as a standard for all their stakeholders in order to optimize their existing risk models.
Investing in a thorough organizational approach when it comes to risks is essential if you want your business succeed!
Wrap Up
The overall message of The Failure of Risk Management by David L Hubbard is a powerful one: we cannot rely on our own human judgement, qualitative descriptions, and basic analysis to properly account for risk.
Rather, it’s essential to apply probabilistic models that factor in calibrated experts and comprehensive variables.
When this is done correctly and all factors are taken into account, it’s possible to successfully manage the risks associated with any endeavor.
This book serves as a great guide on how to accurately detect and manage risk, helping readers make smarter business decisions with greater accuracy.
