What's Your Risk Attitude? (And How Does It Affect Your Company?)

In the best of times or the worst of times — or even in unusually uncertain times — the prevailing opinion about how risky it is to do business is never unanimous. Opinions can be classified into four risk attitudes: Pragmatists, who believe that the world is uncertain and unpredictable; Conservators, whose world belief is of peril and high risk; Maximizers, who see the world as low-risk and fundamentally self-correcting; and Managers, whose world is moderately risky, but not too risky for firms that are guided properly.

Over time, these risk attitudes change via the process of surprise. Surprise is the persistent, and very likely growing, mismatch between what we expect to happen and what actually happens in the real world.

Because firms and individual managers have totally different risk attitudes, there is a varied and varying set of surprises that are happening all the time. Individual managers might expect a moderate market with fluctuations that follow past experiences; an uncertain market with unpredictable volatility; a market boom when everything seems to be going up; or a recession when everything seems to be going down. And business strategies are chosen because of an expectation of a market in one or the other of those states. This means that surprises, when they come, can come in 12 different ways, as shown in the chart below (click to see a larger version).

Along the diagonal of the matrix (see chart) the world is indeed the way it is expected to be — there are no surprises. To understand the surprises in the other 12 boxes, we contrast the strategy that seems sensible to each firm, with the responses the resulting tactics will provoke in each of the actual worlds.

• In the uncertain market
, there is no discoverable pattern to the responses. This is the world of financial uncertainty, when business activity and markets might turn abruptly. Maximizers, Conservators and Managers are all surprised by the lack of predictability of the uncertain market. Each had formed their own idea of what they were predicting and they all end up disappointed.
• In a bust
, there is a discoverable order: the world is a vast negative-sum game. This is the world of the recession. Of course, Maximizers and Managers are surprised. The Maximizers thought that persistent losses would not happen and Managers are surprised by the magnitude of the losses. The Pragmatists are surprised when "correlations all go to one" and their preferred strategy of diversification fails to protect them.
• In a boom,
the reverse happens — the world is a huge positive-sum game. This is when financial bubbles form. Managers and Conservators see the large gains of the Maximizers and are surprised that they can get away with that. Pragmatists see their own larger-than-expected gains and are surprised.
• In moderate market,
there is a discoverable order. This is the "normal" world. The Maximizers will be surprised that they underperform their expectations, while Conservators see the careful risk-taking of the Managers succeeding. Pragmatists are puzzled and surprised by the success of the orderly bean-counting Managers as well.

This process of changing risk attitudes typically takes two routes. First, individual managers will be surprised, as their unmet expectations wear away their convictions about how the world works. As these individuals then shift their risk attitudes, they will also shift their approach to their business and the risks that they're willing to take. If they are very perceptive and adaptable, they will change to a belief that aligns with the current environment and the process will begin again. If they are less adaptable and perceptive, they might shift to a different risk attitude that does not align with the environment. Their firms might then lurch along from one type of sub-optimal performance to another.

The second way that firms adapt is by changing leaders, most often when the firm has been spectacularly surprised. When the board reacts to a collapse — or even to a disappointment — by changing leaders, the new leader then faces the problem of shifting the prevailing risk attitude of the firm. Through a series of persuasions, orders, reorganizations, promotions, retirements and layoffs, the new leader will eventually get the firm's risk attitude to align with what they and the board want it to be.

Meanwhile, the success of the firms that have an approach that aligns with the actual real-world environment will create growth, and the firms with a misaligned approach will shrink relative to each other. The risk attitude that aligns well will eventually control more of the market's resources. That is... until the market shifts again and business leaders find themselves surprised by it.

This article has been adapted from "The Changing Seasons of Risk Attitudes" by David Ingram and Dr. Michael Thompson, which appeared in the December 2011 issue of Risk Management. Risk Management is published by the Joint Risk Management Section Council of Canadian Institute of Actuaries, the Casualty Actuarial Society and the Society of Actuaries.