6 mistakes companies make while assessing their risk

Black Swan events are almost impossible to predict. Instead of coming under the illusion that we can anticipate the future, risk management should try to reduce the impact of the threats we don’t understand.

To change the way we think about risk, we must avoid making six mistakes.

1. You CANNOT manage risk by predicting extreme events. It’s more effective to focus on the consequences. energy companies have finally shifted from predicting when accidents in nuclear plants might happen to preparing for the eventualities.
2. DON’T be convinced that studying past will help you manage risk. Less than 0.25% of all the companies listed in the world represent around half the market capitalization, less than 0.1% of drugs generate a little more than half the pharmaceutical industry’s sales—and less than 0.1% of risky events will cause at least half your losses. It causes winner-take-all effects that have severe consequences.
3. DO pay heed to what you shouldn’t do. Disparagement of negative advice makes companies treat risk management as distinct from profit making and as an afterthought. Instead, corporations should integrate risk-management activities into profit centers and treat them as profit- generating activities, particularly if the companies are susceptible to Black Swan events.
4. DON’T assume that risk can be measured by standard deviation. The standard deviation corresponds to the square root of average squared variations—not average variations. Anyone looking for a single number to represent risk is inviting disaster.
5. What’s mathematically equivalent ISN’T psychologically so. The way a risk is framed influences people’s understanding of it. If you tell investors that, on average, they will lose all their money only every 30 years, they are more likely to invest than if you tell them they have a 3.3% chance of losing a certain amount each year.
6. DON’T ignore redundancy at key places. Mother Nature is the best risk manager of all. Evolution has given us spare parts—we have two lungs and two kidneys, for instance—that allow us to survive.

The biggest risk lies within us: We overestimate our abilities and under-estimate what can go wrong.