JP Castlin wrote a LinkedIn post titled The risk(s) of not understanding risk (May 13, 2024).
« Risk has as close to a universal definition as one may hope of obtain, available via ISO3001. In plain writing, it says that risk is the “effect of uncertainty on objectives”. This means that there are three constituent parts: 1) an effect, 2) uncertainty, and 3) objectives. »
« effect [is] a deviation from the expected (whether positive, negative, or both) »
« In any situation where an active choice is required – where the answer is non-obvious – uncertainty will play a part. It will typically take one of three different forms: it may be aleatoric, epistemic, or systemic. »
- « Aleatoric uncertainty arises due to the unpredictable nature of, well, nature; a randomness that is inherent in a dataset and therefore cannot be reduced… chance… it is fundamentally probabilistic »
- « Epistemic uncertainty, meanwhile, comes out of incomplete data or knowledge; »
- « [Systemic uncertainty]… arises out of the knowledge that you do not know that you do not have, and the things that you cannot see – what is sometimes referred to as the unknown unknowns. In everyday corporate life, this kind of uncertainty habitually takes the form of us believing that we are in one kind of system (usually one in which there is order and traditional risk management methods apply as per above), when in fact we are in another (usually complexity… »
« What they neglect to tell you is that while they [consultants] face an ergodic situation, you (the client) face a non-ergodic one… Without going into details about ergodicity…think of it as manifested repeatability »
« In reality, there often exists points of irreversibility that eliminate repeat efforts; potential failures and negative consequences from which one cannot recover… Global averages do not apply to local failures if they can be catastrophic. »
« Following the advice to make big bets, inevitably made by those without skin in the game from a significantly more resilient position, is thus immensely risky: you face a potentially catastrophic effect on future performance primarily due to systemic uncertainty. They [consultants] do not. »
« If they are using case studies to prove their point… What happened to the companies that tried the same and were unsuccessful? If they have none, why not? (Samples should be randomized and not cherry picked.) » See also survivorship bias.
« If you consider going ahead, what needs to be true for their advice to work? Under what conditions might it work? What funds would you have to redistribute? Would there be investment lag effects and/or negative compounding? How would you know if you were successful and how would you scale it? What indicators would you use? »
« So what should you do? Well, the obvious answer is utilizing an adaptive strategy… all companies have to adapt to changing circumstances in order to avoid strategic drift. »
Articles of Interest 