Despite the large threat it can pose and the amount of resources that are spent in trying to eliminate it, risk continues to be one of the corporate world’s most damaging and elusive concepts. This blog post talks about risk and why it can be so difficult to define.

Just as in ancient times when people had to contend with dragons, harpees and for those who took to primeval waterways the dreaded Cipactli , the modern corporate world has numerous mythical and not-so-mythical monsters that have the ability to intervene in unexpected and inexplicable ways in the business activities of man. 

One of the most potentially damaging of these creatures is Riskasaurus, the embodiment of an endless number of possible negative eventualities that are often condensed into the word risk. Riskasaurus has the unique ability to appear from nowhere, repeatedly change its shape, destroy the most carefully laid business plans and then vanish into thin air. 

Let’s see if we can catch it.   

Riskasaurus is Very Hard to Define

Regardless of whether or not they have written risk management policy, most companies understand the importance of risk management in firm strategy and operations.  However, reducing a general appreciation or fear of risk into a concrete firm wide risk management policy often proves in practice to be extremely challenging.

The very first reason for this has its roots in linguistics rather than finance – the word risk is objectively meaningless. It forms part of that very large set of words in common use whose meaning is easy to grasp at a high level of abstraction but much harder to pin down in specific circumstances.  

If we look at driving as an example, it might be assumed that everyone would agree that car accidents are a universal risk, because they can cause a great deal of damage to drivers, economies and societies who bear in one way or another their costs.  Yet if you are a tow truck operator who makes a living from towing cars that have been involved in accidents, the absence of accidents could well be viewed as a greater risk than the occurrence of them. It far from being an uplifting thought, but the reality is that human inconvenience and suffering form a significant part of a large number of business models.

In finance and economics, the interactive nature of how markets are constructed means that there are benefits and costs in every type of financial transaction and market development. Rising energy prices are a major risk for companies that use a lot of energy but a boon to companies with supply side business models.  Rising rents are a risk for tenants but good for owners.

Even within the same companies, risk is often viewed differently across horizontal and vertical corporate lines.  For employees, a dramatic increase in the receipt of employment checks would likely be seen as anything but risky but for an overworked payroll department it could represent stretching thin available human resources even further. The elimination of risk also creates another type of risk and vice versa.

Riskasaurus Constantly Changes its Shape

A second reason that risk is hard to define is that risk is not a static concept that remains fixed regardless of market conditions or a company’s internal operating realities; it changes constantly as circumstances shift. 

If we consider as an example a start-up company at an early part of its growth cycle, it may be capable of managing all key business activities with very few people.  As the business grows, however, and more people need to be hired, organizational dynamics will often significantly changes.  These changes will create many new types of risks, including how information is stored and handled, how effectively executive decisions are implemented and how the firm interacts with clients. 

Changing risk realities are also a function of the fact that nothing in the business world is static:  the unstoppable march of time creates changes; changes creates new realities; and new realities create new risks.  A real estate company during a period of flat market growth may find it relatively easy to employ construction workers.  However, if market growth starts to accelerate and there is more and more construction activity, finding qualified construction workers at a reasonable cost could become increasingly difficult.

Riskasaurus Has the Ability to Multiply Itself

Another quality of risk is that it can multiply itself both quantitatively and qualitatively.  On the quantitative side, since many types of risk are a function of time, the longer a period of time increases, the more types of risks can materialize.  For example, let’s say that when a tennis match starts the risks that affect a tennis player are represented by the set X.  As the match continues and tennis player becomes tired and potentially dehydrated, the number of risks will increase. Of course, it is true that the passage of time can eliminate risks, so a time series snapshot of a company’s risk exposure would be more complicated than the tennis example suggests, but as a general rule risk tends to increase with time.

Qualitatively, risks can also multiply themselves due to human ingenuity and the fact that a large amount of human behavior involves making relatively small changes to existing behavioral examples rather than inventing something completely out of the blue.  This means in simple terms it may have taken society a long time to invent terrorism, but once a terrorist act occurred variants of that act started to happen in broad historical terms at a significantly faster rate.

Using a Flexible Trap to Catch a Flexible Creature

Given the many challenges involving defining risk, many businesses give up systematically trying to define risk and risk definition and risk management becomes an adhoc process where risks are not prevented or, often equally as damaging for a company, risk management costs outweigh risk management benefits.

The better approach is to recognize that, in order to define relevant risk for a firm, a dynamic process is required which requires continuing analysis of a firm and the market its operates in, an understanding of how conditions are changing and what risks these conditions are creating for a firm.