Finance: The fallout after the gold rush

Business is often a gamble but too often investors risk finance without weighing up the dangers.

BUSINESS, AS anybody who has been involved in a start-up knows, is largely about risk. It is all very well envying the success of investors in Microsoft and Intel, but back when these corporations were just gleams in the eyes of their founders, putting up the money to turn those dreams into reality involved a lot of risk.

For this reason, it is not always possible to be sympathetic with the "victims" of corporate collapses. Investing in stock markets is - as the small print now points out - an inherently risky business.

But it is not just individuals who get caught out in this way. You have only to look at how insurance companies - which might be expected to make risk a core part of their business - howled with pain when the sharper- than-expected downturn in the UK housing market in the early Nineties led to correspondingly large pay-outs on mortgage indemnity policies issued when the market was booming in the Eighties.

Or there is the situation in the Far East, which only a short time ago was regarded by many companies as a land of limitless opportunity, but is now seen as an extremely dangerous region for investment.

If such mistakes are happening on such a scale, then maybe the conventional models for assessing risk are inappropriate. This is the argument of Ron Dembo and Andrew Freeman, a risk-analysis consultant and financial journalist respectively, in their book Seeing Tomorrow (John Wiley & Sons, pounds 19.99). As the subtitle Rewriting the Rules of Risk indicates, they are setting out to improve the ability to make important decisions and - accordingly - change the way in which investments and other financial decisions are made.

Much of their focus is on the business arena. They explain how even George Soros slipped up when he became involved in a property development with the Reichmanns in Mexico City that failed to go ahead as envisaged after the country's economy hit a downturn. But they also explain how their approach may apply to the housing market, where even they found themselves caught out by the cycle.

At the heart of their theory are the related concepts of "upside" and "downside", or, as they term the latter, "regret". Essentially, risk is all about analysing a situation to see if "U" outweighs "R". Regret, they argue, is more useful than existing risk measures because "it can reflect our appetites for risk".

To understand this better, they introduce the concept of "risk-adjusted value - value that has been altered to take into account our personal attitude towards risk". Recognising that we are more prone to risk in some circumstances than in others, they have come up with a "risk aversion constant" that they give the Greek symbol, lambda.

"Another way to think of lambda is as a margin or insurance premium that we might decide to put against our possible losses, in the event that our upside fails to materialise," write Dembo and Freeman. "The larger the value for lambda, the more risk-averse the decision maker, because he or she is paying a higher price to self-insure the risk."

Pointing out that most of us are risk-averse, they add that another way of putting this is to say that most people would like to have the assurance that they have set aside enough funds to protect their downside. Hence the oft-repeated warning to stock-market investors and casino gamblers alike not to bet more than they can afford to lose.

But, though the language is full of complex mathematics, what they are really getting at is the need to think more clearly about risk. Too often, people - whether acting in business or as individuals - seem to pay insufficient attention to weighing up the pros and cons of situations.

Even supposedly sophisticated organisations often fall in with the herd mentality rather than making their own analyses. Hence, so many banks were left nursing substantial losses when the commercial property market collapsed. They all followed each other into a market that, though it started out lucrative, quickly became catastrophic.

Similarly, many Lloyd's Names were caught out because past performance had indicated that becoming a member of an insurance syndicate was a certain way to make even more money than they had already. Of course, if they had thought about the true nature of what they were entering into, it would have occurred to them that the downside of making lots of money was the risk of losing even more.

But it is not just that people and businesses can get carried away by the Upside. They can also, as David and Jim Matheson, the authors of The Smart Organisation (Harvard Business School Press), point out, react in knee-jerk fashion to bad news.

Accordingly, they say, the turmoil in the Far East's financial markets is not bad news for everybody. While companies might want to be wary of becoming involved in public-sector projects or initiatives that require investments from indigenous companies, they can - for instance - find cheap manufacturing opportunities.

With the Mathesons convinced that what really sets apart the great businesses is an ability to make the right decisions, a model that offers a better understanding of the nature of risk could well fall on fertile ground.

Arts and Entertainment
Jude Law in Black Sea

film

In Black Seahe is as audiences have never seen him before

Arts and Entertainment
Johnny Depp no longer cares if people criticise his movie flops

film

Arts and Entertainment
Full circle: Wu-Tang’s Method Man Getty

Music review

Arts and Entertainment
When he was king: Muhammad Ali training in 'I Am Ali'
film
Arts and Entertainment
Joel Edgerton, John Turturro and Christian Bale in Exodus: Gods and Kings
film Ridley Scott reveals truth behind casting decisions of Exodus
PROMOTED VIDEO
Arts and Entertainment
Scare tactics: Michael Palin and Jodie Comer in ‘Remember Me’

TVReview: Remember Me, BBC1
Arts and Entertainment
Scare tactics: Michael Palin and Jodie Comer in ‘Remember Me’

TVReview: Remember Me, BBC1
Have you tried new the Independent Digital Edition apps?
Arts and Entertainment

ebooksNow available in paperback
Arts and Entertainment

ebooks
Arts and Entertainment
Carrie Hope Fletcher
booksFirst video bloggers conquered YouTube. Now they want us to buy their books
Arts and Entertainment
Damien Hirst
artCoalition's anti-culture policy and cuts in local authority spending to blame, says academic
Arts and Entertainment
A comedy show alumni who has gone on to be a big star, Jon Stewart
tvRival television sketch shows vie for influential alumni
Arts and Entertainment
Jason goes on a special mission for the queen
tvReview: Everyone loves a CGI Cyclops and the BBC's Saturday night charmer is getting epic
Arts and Entertainment
Image has been released by the BBC
tv
Arts and Entertainment
Will there ever be a Friends reunion?
TV
News
Harry Hill plays the Professor in the show and hopes it will help boost interest in science among young people
arts + ents
Arts and Entertainment
A Van Gogh sold at Sotheby’s earlier this month
art
Arts and Entertainment

MusicThe band accidentally called Londoners the C-word

Arts and Entertainment
It would 'mean a great deal' to Angelina Jolie if she won the best director Oscar for Unbroken

Film 'I've never been comfortable on-screen', she says

Arts and Entertainment
Winnie the Pooh has been branded 'inappropriate' in Poland
books
Arts and Entertainment
Lee Evans is quitting comedy to spend more time with his wife and daughter

comedy
Arts and Entertainment
American singer, acclaimed actor of stage and screen, political activist and civil rights campaigner Paul Robeson (1898 - 1976), rehearses in relaxed mood at the piano.
filmSinger, actor, activist, athlete: Paul Robeson was a cultural giant. But prejudice and intolerance drove him to a miserable death. Now his story is to be told in film...
Arts and Entertainment
Taylor Swift is dominating album and singles charts worldwide

music
Arts and Entertainment
Kieron Richardson plays gay character Ste Hay in Channel 4 soap Hollyoaks

tv
Arts and Entertainment
Midge Ure and Sir Bob Geldof outside the Notting Hill recording studios for Band Aid 30

music
Latest stories from i100
Have you tried new the Independent Digital Edition apps?

ES Rentals

    Independent Dating
    and  

    By clicking 'Search' you
    are agreeing to our
    Terms of Use.

    Homeless Veterans Christmas Appeal: ‘We give them hope. They come to us when no one else can help’

    Christmas Appeal

    Meet the charity giving homeless veterans hope – and who they turn to when no one else can help
    Should doctors and patients learn to plan humane, happier endings rather than trying to prolong life?

    Is it always right to try to prolong life?

    Most of us would prefer to die in our own beds, with our families beside us. But, as a GP, Margaret McCartney sees too many end their days in a medicalised battle
    Thomas Cook's outgoing boss Harriet Green got by on four hours sleep a night - is that what it takes for women to get to the top?

    What does it take for women to get to the top?

    Thomas Cook's outgoing boss Harriet Green got by on four hours sleep a night and told women they had to do more if they wanted to get on
    Christmas jumper craze: Inside the UK factory behind this year's multicultural must-have

    Knitting pretty: British Christmas Jumpers

    Simmy Richman visits Jack Masters, the company behind this year's multicultural must-have
    French chefs have launched a campaign to end violence in kitchens - should British restaurants follow suit?

    French chefs campaign against bullying

    A group of top chefs signed a manifesto against violence in kitchens following the sacking of a chef at a Paris restaurant for scalding his kitchen assistant with a white-hot spoon
    Radio 4 to broadcast 10-hour War and Peace on New Year's Day as Controller warns of cuts

    Just what you need on a New Year hangover...

    Radio 4 to broadcast 10-hour adaptation of War and Peace on first day of 2015
    Cuba set to stage its first US musical in 50 years

    Cuba to stage first US musical in 50 years

    Claire Allfree finds out if the new production of Rent will hit the right note in Havana
    Christmas 2014: 10 best educational toys

    Learn and play: 10 best educational toys

    Of course you want them to have fun, but even better if they can learn at the same time
    Paul Scholes column: I like Brendan Rodgers as a manager but Liverpool seem to be going backwards not forwards this season

    Paul Scholes column

    I like Brendan Rodgers as a manager but Liverpool seem to be going backwards not forwards this season
    Lewis Moody column: Stuart Lancaster has made all the right calls – now England must deliver

    Lewis Moody: Lancaster has made all the right calls – now England must deliver

    So what must the red-rose do differently? They have to take the points on offer 
    Cameron, Miliband and Clegg join forces for Homeless Veterans campaign

    Cameron, Miliband and Clegg join forces for Homeless Veterans campaign

    It's in all our interests to look after servicemen and women who fall on hard times, say party leaders
    Millionaire Sol Campbell wades into wealthy backlash against Labour's mansion tax

    Sol Campbell cries foul at Labour's mansion tax

    The former England defender joins Myleene Klass, Griff Rhys Jones and Melvyn Bragg in criticising proposals
    Nicolas Sarkozy returns: The ex-President is preparing to fight for the leadership of France's main opposition party – but will he win big enough?

    Sarkozy returns

    The ex-President is preparing to fight for the leadership of France's main opposition party – but will he win big enough?
    Is the criticism of Ed Miliband a coded form of anti-Semitism?

    Is the criticism of Miliband anti-Semitic?

    Attacks on the Labour leader have coalesced around a sense that he is different, weird, a man apart. But is the criticism more sinister?
    Ouija boards are the must-have gift this Christmas, fuelled by a schlock horror film

    Ouija boards are the must-have festive gift

    Simon Usborne explores the appeal - and mysteries - of a century-old parlour game