I just started reading a book yesterday called Strategic Risk Taking: A Framework For Risk Management. It’s by Aswath Damodaran, Professor of Finance at NYU’s Stern School of Business.
In chapter 1, Damodaran introduced the concept of risk and provided a couple of definitions for risk from different perspectives, as well as what factors are associated with risk.
He also wrote something I haven’t been able to get out of my head, which is why I’m blogging about it today:
“In a paper on defining risk, Holton (2004) argues that two ingredients are needed for risk to exist. The first is uncertainty about the potential outcomes from an experiment, and the other is that the outcomes have to matter in terms of providing a utility. He notes, for instance, that a person jumping out of an airplane without a parachute faces no risk since he is certain to die…” Damodaran, Aswath. (2008). Strategic Risk Taking: A Framework For Risk Management. New Jersey: Wharton School Publishing.
This definition transforms the idea of risk for me.
To help me break down what Holton is saying (according to Damodaran), we can put Holton’s ideas into a little matrix:
So you have 4 possible outcomes:
- A: No uncertainty and no utility. Well, we know right away that this is no risk because we already know the outcome (no uncertainty) but it doesn’t matter to us anyway (no utility).
- B: No uncertainty but there is utility. This is where every single business wants to operate. I believe that the goal of risk management is to put business owners and investors in this position. Also, this is where the parachute-less jumper is (in Damodaran’s quote above).
- C: Uncertainty but no utility. This isn’t really where we want our business and investments, I think. We don’t know what will happen but it doesn’t really matter… kind of like watching Americn Idol maybe?
- D: Uncertainty and utility. This is when we don’t know what the outcome will be but the outcome does matter. This is risk, according to Holton.
Can business owners and investors alter the uncertainty or utility? Can they reduce the uncertainty and increase the utility (or vice versa) if necessary? How much control is involved in this definition of uncertainty. How much foreknowledge is required for someone to be uncertain? (For example, what if the person jumping out of the plane thought they couldn’t die? Although we all know there would be utility, that jumper wouldn’t THINK there was utility — isn’t that a risk in itself?)
This is fascinating. I’m going to keep thinking about this as I read and I’ll share more as I go.