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

eurovision
Arts and Entertainment
Fearne Cotton is leaving Radio 1 after a decade

radio
Arts and Entertainment
The light stuff: Britt Robertson and George Clooney in ‘Tomorrowland: a World Beyond’
film review
Arts and Entertainment
Reawakening: can Jon Hamm’s Don Draper find enlightenment in the final ‘Mad Men’?
tv reviewNot quite, but it's an enlightening finale for Don Draper spoiler alert
Arts and Entertainment
Breakfast Show’s Nick Grimshaw

Radio
Have you tried new the Independent Digital Edition apps?
Arts and Entertainment

ebooksNow available in paperback
Arts and Entertainment

ebooks
Arts and Entertainment
I am flute: Azeem Ward and his now-famous instrument
music
Arts and Entertainment
A glass act: Dr Chris van Tulleken (left) and twin Xand get set for their drinking challenge
TV review
Arts and Entertainment
MIA perform at Lovebox 2014 in London Fields, Hackney

music
Arts and Entertainment
Finnish punk band PKN hope to enter Eurovision 2015 and raise awareness for Down's Syndrome

eurovision
Arts and Entertainment
William Shakespeare on the cover of John Gerard's The Herball or Generall Historie of Plantes

books
Arts and Entertainment

Game of Thrones review
Arts and Entertainment
Grayson Perry dedicates his Essex home to Julie

Potter's attempt to create an Essex Taj Mahal was a lovely treat

tv
Arts and Entertainment
A scene from the original Swedish version of the sci-fi TV drama ‘Real Humans’
tv
Arts and Entertainment
Hugh Keays-Byrne plays Immortan Joe, the terrifying gang leader, in the new film
filmActor who played Toecutter returns - but as a different villain in reboot
Arts and Entertainment
Charlize Theron as Imperator Furiosa in Mad Max: Fury Road
film
Arts and Entertainment
Jessica Hynes in W1A
tvReview: Perhaps the creators of W1A should lay off the copy and paste function spoiler alert
Arts and Entertainment
Power play: Mitsuko Uchida in concert

classical
Arts and Entertainment
Dangerous liaisons: Dominic West, Jake Richard Siciliano, Maura Tierney and Leya Catlett in ‘The Affair’ – a contradictory drama but one which is sure to reel the viewers in
TV review
Arts and Entertainment
Richard Herring, pictured performing at the Edinburgh Fringe Festival two years ago
comedy
Arts and Entertainment
Music freak: Max Runham in the funfair band
theatre
Arts and Entertainment
film 'I felt under-used by Hollywood'
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.

    Sun, sex and an anthropological study: One British academic's summer of hell in Magaluf

    Sun, sex and an anthropological study

    One academic’s summer of hell in Magaluf
    From Shakespeare to Rising Damp... to Vicious

    Frances de la Tour's 50-year triumph

    'Rising Damp' brought De la Tour such recognition that she could be forgiven if she'd never been able to move on. But at 70, she continues to flourish - and to beguile
    'That Whitsun, I was late getting away...'

    Ian McMillan on the Whitsun Weddings

    This weekend is Whitsun, and while the festival may no longer resonate, Larkin's best-loved poem, lives on - along with the train journey at the heart of it
    Kathryn Williams explores the works and influences of Sylvia Plath in a new light

    Songs from the bell jar

    Kathryn Williams explores the works and influences of Sylvia Plath
    How one man's day in high heels showed him that Cannes must change its 'no flats' policy

    One man's day in high heels

    ...showed him that Cannes must change its 'flats' policy
    Is a quiet crusade to reform executive pay bearing fruit?

    Is a quiet crusade to reform executive pay bearing fruit?

    Dominic Rossi of Fidelity says his pressure on business to control rewards is working. But why aren’t other fund managers helping?
    The King David Hotel gives precious work to Palestinians - unless peace talks are on

    King David Hotel: Palestinians not included

    The King David is special to Jerusalem. Nick Kochan checked in and discovered it has some special arrangements, too
    More people moving from Australia to New Zealand than in the other direction for first time in 24 years

    End of the Aussie brain drain

    More people moving from Australia to New Zealand than in the other direction for first time in 24 years
    Meditation is touted as a cure for mental instability but can it actually be bad for you?

    Can meditation be bad for you?

    Researching a mass murder, Dr Miguel Farias discovered that, far from bringing inner peace, meditation can leave devotees in pieces
    Eurovision 2015: Australians will be cheering on their first-ever entrant this Saturday

    Australia's first-ever Eurovision entrant

    Australia, a nation of kitsch-worshippers, has always loved the Eurovision Song Contest. Maggie Alderson says it'll fit in fine
    Letterman's final Late Show: Laughter, but no tears, as David takes his bow after 33 years

    Laughter, but no tears, as Letterman takes his bow after 33 years

    Veteran talkshow host steps down to plaudits from four presidents
    Ivor Novello Awards 2015: Hozier wins with anti-Catholic song 'Take Me To Church' as John Whittingdale leads praise for Black Sabbath

    Hozier's 'blasphemous' song takes Novello award

    Singer joins Ed Sheeran and Clean Bandit in celebration of the best in British and Irish music
    Tequila gold rush: The spirit has gone from a cheap shot to a multi-billion pound product

    Join the tequila gold rush

    The spirit has gone from a cheap shot to a multi-billion pound product
    12 best statement wallpapers

    12 best statement wallpapers

    Make an impact and transform a room with a conversation-starting pattern
    Paul Scholes column: Does David De Gea really want to leave Manchester United to fight it out for the No 1 spot at Real Madrid?

    Paul Scholes column

    Does David De Gea really want to leave Manchester United to fight it out for the No 1 spot at Real Madrid?