Monitoring Trends to Mitigate Risk
In this article, Barry Horwitz highlights the value of risk and how to track trends that may foreshadow problems.
In the early weeks of March, many in the tech sector were surprised and distressed by the sudden collapse of a once-great institution, Silicon Valley Bank (SVB). Founded in 1983, it was the 16th largest bank in the US and was a very active and positive influence on the technology sector — in Silicon Valley, of course, but also significantly in the Boston area.
There are a variety of explanations behind this sudden turn of events. But there was one primary issue: the bank did not adequately plan for the very small probability of a very bad outcome.
To vastly oversimplify what happened, SVB assumed interest rates would stay low for the foreseeable future (as they had in the recent past) and made investment decisions based on that expectation. It made sense… until it didn’t, when the very bad, very small probability event occurred: a dramatic increase in interest rates over a short period of time.
It’s not that the bank had no warning — indeed, it was notified more than a year prior of the excessive risk it was carrying by the Federal Reserve Bank (The Fed). Or that its leaders didn’t understand what would happen if rates rose quickly and significantly. But one presumes they took comfort in the fact that while the consequences could be severe, the likelihood of it happening was small.
But small risk is not zero risk. And that’s a problem for all of us — humans have difficulty imagining these situations.
For example, many years ago I was involved in a project with a major telecommunications company that enjoyed a highly profitable business leasing telephones to consumers. They had begun to experience a rapid erosion of this business and I built a model to test several possible scenarios to gauge the impact of various responses.
Despite using reasonable (and sometimes even aggressively positive) assumptions, the model suggested that there was no way to reverse the trend. The client’s response? Keep working on the model until you get the outcome we want. I tried several more times, but reality refused to listen.
Key points include:
Degrees of risk
Responding to signs
Possible plans of action
Read the full article, Small Risk Is not Zero Risk, on HorwitzandCo.com.