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
Emo rockers Fall Out Boy

music

Arts and Entertainment
Jamie Dornan as Christian Grey in Fifty Shades of Grey

film Sex scene trailer sees a shirtless Jamie Dornan turn up the heat

Arts and Entertainment

film

Arts and Entertainment
A sketch of Van Gogh has been discovered in the archives of Kunsthalle Bremen in Germany
arts + ents
Arts and Entertainment
Eleanor Catton has hit back after being accused of 'treachery' for criticising the government.
books
PROMOTED VIDEO
Arts and Entertainment
Taylor Swift is heading to Norwich for Radio 1's Big Weekend

music
Arts and Entertainment
Beer as folk: Vincent Franklin and Cyril Nri (centre) in ‘Cucumber’
tvReview: This slice of gay life in Manchester has universal appeal
Have you tried new the Independent Digital Edition apps?
Arts and Entertainment

ebooksNow available in paperback
Arts and Entertainment

ebooks
Arts and Entertainment
‘A Day at the Races’ still stands up well today
film
Arts and Entertainment
‘The Royals’ – a ‘twisted, soapy take on England’s first family’
tvAnd its producers have already announced a second season...
Arts and Entertainment
Kraftwerk performing at the Neue Nationalgalerie (New National Gallery) museum in Berlin earlier this month
musicWhy a bunch of academics consider German electropoppers Kraftwerk worthy of their own symposium
Arts and Entertainment
Icelandic singer Bjork has been forced to release her album early after an online leak

music
Arts and Entertainment
Colin Firth as Harry Hart in Kingsman: The Secret Service

film
Arts and Entertainment
Brian Blessed as King Lear in the Guildford Shakespeare Company's performance of the play

theatre
Arts and Entertainment
In the picture: Anthony LaPaglia and Martin Freeman in 'The Eichmann Show'

tv
Arts and Entertainment
Anne Kirkbride and Bill Roache as Deirdre and Ken Barlow in Coronation Street

tvThe actress has died aged 60
Arts and Entertainment
Marianne Jean-Baptiste defends Joe Miller in Broadchurch series two

tv
Arts and Entertainment
The frill of it all: Hattie Morahan in 'The Changeling'

theatre
Arts and Entertainment
Gillian Anderson and David Duchovny may reunite for The X Files

tv
Arts and Entertainment
Jeremy Clarkson, left, and Richard Hammond upset the locals in South America
TV
News
A young woman punched a police officer after attending a gig by US rapper Snoop Dogg
people
Arts and Entertainment
Reese Witherspoon starring in 'Wild'

It's hard not to warm to Reese Witherspoon's heroismfilm
Arts and Entertainment
Word up: Robbie Coltrane as dictionary guru Doctor Johnson in the classic sitcom Blackadder the Third
books

Arts and Entertainment
The Oscar nominations are due to be announced today

Oscars 2015
Arts and Entertainment
Hacked off: Maisie Williams in ‘Cyberbully’

Maisie Williams single-handedly rises to the challenge

TV
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.

    As in 1942, Germany must show restraint over Greece

    As in 1942, Germany must show restraint over Greece

    Mussolini tried to warn his ally of the danger of bringing the country to its knees. So should we, says Patrick Cockburn
    Britain's widening poverty gap should be causing outrage at the start of the election campaign

    The short stroll that should be our walk of shame

    Courting the global elite has failed to benefit Britain, as the vast disparity in wealth on display in the capital shows
    Homeless Veterans appeal: The rise of the working poor: when having a job cannot prevent poverty

    Homeless Veterans appeal

    The rise of the working poor: when having a job cannot prevent poverty
    Prince Charles the saviour of the nation? A new book highlights concerns about how political he will be when he eventually becomes king

    Prince Charles the saviour of the nation?

    A new book highlights concerns about how political he will be when he eventually becomes king
    How books can defeat Isis: Patrick Cockburn was able to update his agenda-setting 'The Rise of Islamic State' while under attack in Baghdad

    How books can defeat Isis

    Patrick Cockburn was able to update his agenda-setting 'The Rise of Islamic State' while under attack in Baghdad
    Judith Hackitt: The myths of elf 'n' safety

    Judith Hackitt: The myths of elf 'n' safety

    She may be in charge of minimising our risks of injury, but the chair of the Health and Safety Executive still wants children to be able to hurt themselves
    The open loathing between Barack Obama and Benjamin Netanyahu just got worse

    The open loathing between Obama and Netanyahu just got worse

    The Israeli PM's relationship with the Obama has always been chilly, but going over the President's head on Iran will do him no favours, says Rupert Cornwell
    French chefs get 'le huff' as nation slips down global cuisine rankings

    French chefs get 'le huff' as nation slips down global cuisine rankings

    Fury at British best restaurants survey sees French magazine produce a rival list
    Star choreographer Matthew Bourne gives young carers a chance to perform at Sadler's Wells

    Young carers to make dance debut

    What happened when superstar choreographer Matthew Bourne encouraged 27 teenage carers to think about themselves for once?
    Design Council's 70th anniversary: Four of the most intriguing prototypes from Ones to Watch

    Design Council's 70th anniversary

    Four of the most intriguing prototypes from Ones to Watch
    Dame Harriet Walter: The actress on learning what it is to age, plastic surgery, and her unease at being honoured by the establishment

    Dame Harriet Walter interview

    The actress on learning what it is to age, plastic surgery, and her unease at being honoured by the establishment
    Art should not be a slave to the ideas driving it

    Art should not be a slave to the ideas driving it

    Critics of Tom Stoppard's new play seem to agree that cerebral can never trump character, says DJ Taylor
    Bill Granger recipes: Our chef's winter salads will make you feel energised through February

    Bill Granger's winter salads

    Salads aren't just a bit on the side, says our chef - their crunch, colour and natural goodness are perfect for a midwinter pick-me-up
    England vs Wales: Cool head George Ford ready to put out dragon fire

    George Ford: Cool head ready to put out dragon fire

    No 10’s calmness under pressure will be key for England in Cardiff
    Michael Calvin: Time for Old Firm to put aside bigotry and forge new links

    Michael Calvin's Last Word

    Time for Old Firm to put aside bigotry and forge new links