For more than 300 years we have used the same formula for calculating the cost of risk: Risk = Probability x Consequence. In research done in the last 10 years, we have shown that this is an insufficient formula. We have shown that when an outcome in the future is a high (relatively) negative value (cost) the formula is consistently under valuating the cost of risk (link to references).
Most people will immediately discard the idea, that the formula of risk, being the foundation of the theory on capital, insurance, diversifications and much more can ever be changed. But I ask that you give it some consideration.
In experimental research we have shown that when an agent suffers a large negative cost, that same agents long term investments may end up suffering, as financing intended for the long term investments is used to cover the unexpected cost. This is highly problematic as long term investments often has no market value, or a poorly established market value. An example is an investment into an education. The half-completed education cannot be sold, as the knowledge is in the brain of the investor (student). Same goes for many other long term investments - there are poor, or no markets for these investments. Even if such investments have no market value, it does not mean they have no value for society.
Large future cost items (items exceeding the capital of the investor) can result in a cost cascade, whereby value is lost on long term investments, and such loss is characterized by:
- Not being visible to the surroundings
- Equilibrium in market cannot be established
- Is a value destructive cost mechanism
- The cost item (impaired long term investments) can be of any size, and can even exceed the direct cost suffered
To account for such as loss we would need to modify the formula for the cost of risk. We propose using Risk = (Probability x Consequence) + Structural Risk Cost
If we accept this fundamental change to risk literature we will have a risk theory where:
- Capital reserves has an economic value higher than that of savings
- Risk theory becomes more logical to laymen and experts (today the cost of a bet where an outcome (of many) is to lose 50.000 Euro has the same economic value when presented to a poor student and a millionaire, which is counterintuitive
- Some of the behavioral economy literature will need be rewritten, as what was previously irrational behavior now becomes logical (Keynes Saving Paradox/ Paradox of Thrift is no longer a paradox, but a logical behavior).
So there is much to gain by changing this ancient definition of risk – but is it at all possible to change such an ancient set in stone definition and should we try to do it, or should we just ignore this as it is too complicated and move on fixing the economic theory with the "duct tape" of behavioral economics
http://www.palgrave.com/gb/book/9783319413686
Article Risk, resources and structures: Experimental evidence of a n...
Check out CVaR - conditional value-at-risk, as defined by Uryasev and Rockefellar.
Michael,
Yes I know the literature.
VaR and CVaR and other iterations of Value at Risk, are assessments made to help the investor judge, if components of the portfolio is outside the risk appetite of the investor. In this way VaR is a tool aiming at helping an investor judge the quality of the portfolio, not the absolute value. In fact VaR/ CVaR provides you with no updated value estimate of your portfolio, but it may cause you to change your preference towards parts of your investments based on the analysis and your personal risk preferences or risk appetite.
That is not the point of my post. I propose to change how we calculate the value of the components of the portfolio e.g. the value of a single investment
Valuating an investment by a method of analysis such as real option analysis will give you a value, based on the various outcomes or options, and their respective likelihood. Our research shows that value to be consistently overestimating the value of a specific type of investments: Investments, where an outcome or option is a negative value (cost) that exceeds the available free capital (savings) of the investor.
Or to put it bluntly: We calculate the value of a future game of flip the coin, where Heads gives you Euro 10.000 and tails makes you lose euro 5.000 in the wrong way today.
If Euro 5.000 exceeds your savings (or reserves), the economic value calculated is wrong, as you have no idea about what the financing cost will be of the potential future deficit. If you manage to secure funding in the market e.g. a bank, it is not a problem. But if funding cannot be secured, you may impair the value of long term investments. And such cost is problematic and unaccounted for in current economic theory. It is not a part of how we calculate the value of a game of flip the coin. And for this reason, the above example of a game of flip the coin will have exactly the same financial value when presented to a millionaire and to a poor student.
It makes no sense that the game has the same financial value no matter the financial strength and capability of the investor. We need change this.
May I suggest that calculation is not the prime issue but definition. Environmental risk has specific characteristics that separate it from traditional pollution problems and affect how it is calculated. See my book Justice & Nature, Chapters 2 and 4 for details.
John,
It is most certainly not a matter of definition.
I'm challenging a calculation, so it is how we calculate it that matters.
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