Long before the geopolitical tumult of Arab Spring and the devastation of the Tsunami in Japan, before the emergency response TARP bailouts and the age-defining morning of September 11, an otherwise inconsequential note appeared at the bottom of the business pages: home prices in the United States had risen by 1.7 percent.
It was 1995 and, indeed, a different world. Over the next 10 years, home prices continued to rise at an accelerating rate, finally climaxing in 2005 at 15.7 percent, which put values at more than double their 1995 level.
Such growth could never have happened without the widespread acceptance of a single unshakable truth: that housing values were inherently stable. Had buyers considered that, as in the past, property could change in value, the idea of buying a home would have appeared riskier. Lenders might not have issued mortgages with minimal down payments; banks wouldn't have sold dubious high-margin complex derivative contracts with juiced profits; shoddy triple-A ratings wouldn't have entangled the global banking system and perhaps the world economy wouldn't have been brought to its knees.
The debacle we have watched over the last four years all comes back to the value and definition of two commonly used words: risk management. The prevailing risk management strategies practiced during those bubble years was largely focused on the wrong risks.
For instance, a reversal in home prices was certainly a risk to be measured, but it appears to have played little to no role, or at least one that never seemed to matter.
These are issues, obviously, not limited to the financial turmoil we're just only beginning to emerge from. They strike at the very heart of the four-letter word "risk." Risk management is a wholly toothless concept when its true definition is ignored. Risk, in many ways, isn't so much the chance of loss or peril so much as the reality that more things can happen than we appreciate—and some inevitably will.
The greatest risks are never the ones you can see or measure. They're the ones you can't see and therefore can never measure. They're the ones that seem so far outside the boundaries of practical probability that you can't imagine they could happen in a lifetime: a tsunami setting off a series of nuclear meltdowns; the collapse of a foundation such as Lehman Brothers; the epic fraud of a Bernie Madoff.
Sometimes that risk works the other way. The iPod was developed in less than 12 months and ultimately created a technology and cultural revolution.
How will we deal with those surprises and the consequences they present is when risk management begins to live up to its true meaning.
The theme of risk—both in its randomness and its inevitability—is touched on in a several stories in this issue of Business Finance.
Perhaps no word has resonated louder over the last year than that of volatility. We would like our risk management systems to account for those unknown tremors. The problem is volatility, while often a symptom of risk, is not a risk in and of itself. It clouds certainty, but it does not necessarily determine our fate.
The most effective risk management centers on the premise that forecasts aren't ironclad and consequences have to be weighed. After all, more things can happen than we appreciate -- and some inevitably will.