The Failure of Risk Management | Douglas W. Hubbard

Summary of: The Failure of Risk Management: Why It’s Broken and How to Fix It
By: Douglas W. Hubbard

Introduction

Embark on a journey to master the art of risk management with Douglas W. Hubbard’s ‘The Failure of Risk Management: Why It’s Broken and How to Fix It’. This book offers insight into the flawed methods commonly used in assessing and managing risks, demonstrating the need to adopt more scientifically accurate models. The book also educates readers on significant developments in the history of risk management, from wartime applications to its present-day use in organizations and governments. Ultimately, the book serves as a valuable resource for understanding, evaluating, and improving risk management practices.

Unpacking Risk Management

Risk management is the process of utilizing limited resources to minimize the probability and magnitude of undesirable events.

Risk management refers to the process of effectively using limited resources to minimize the probability and magnitude of undesirable events. Probability refers to the odds that something undesirable will happen, while magnitude can be measured in various dimensions such as loss of money or lives. A risk manager tries to minimize risk by reducing the probability of pursuing an objective. Managing risk is characterized by planning, organizing, coordinating, and directing resources towards defined objectives using the available resources to achieve a required objective. The process also involves reducing the probability of encountering an undesirable event. Risk management has become part of the jargon used among organizations, governments, and people globally. The approach explains how an organization could limit disaster occurrences, product recalls, and political instability. To ensure risk management is successful, a manager ought to identify potential risks and develop an effective approach to counteract them. Effective risk management helps an organization to achieve efficiency and effectiveness by utilizing resources to complete essential tasks.

The Evolution of Risk Management

From war quants to today’s corporations, risk management has come a long way. The digitization of the field and the increased sophistication brought on by the risk associated with nuclear power and oil exploration in the 1940s have made risk management an important field in the minds of most large organizations today. Risk analysis during World War II and the Cold War by engineers and economists was a major breakthrough for the field. Today, risk is analyzed and managed in various organizations, from governmental institutions to corporations. Studies have shown that the function of risk management is increasing on an organizational level, with many companies hiring or intending to hire a Chief Risk Officer. With the constant changes and increased complexity of today’s world, the significance of risk management continues to grow.

Flaws in Common Risk Management Methods

Risk management is crucial, but the most widely used methods have various shortcomings. Qualitative descriptions, like “very likely,” lead to different interpretations among collaborators. The scoring method fails to consider the relationship between risks, leading to common mode risk. Those methods rely only on expert opinions which may not always be reliable. These limitations undermine the effectiveness of risk management, highlighting the need for reform.

The Pitfalls of Expert Opinion

The reliance on expert opinion for assessing risks may not be as helpful as one might think. According to research, people tend to overestimate their abilities and underestimate risks, even experts. Biases from past experiences and flawed memory also affect one’s ability to evaluate probability accurately. Studies by psychologists suggest that our minds are influenced by biases such as the peak end rule, which affects our memories of extreme and recent experiences. Therefore, people tend to assume inaccuracies in weather forecasts if one past picnic was ruined by rain, despite the low probability of rain in the forecast. The book suggests caution when using expert opinion in risk management, as even esteemed experts are affected by these tendencies.

Improving Expert Opinion

The book highlights calibration training as a means to improve expert opinion. This type of training emphasizes repetition and feedback. There are many ways to calibrate, but one method involves range testing where the testee provides lower and higher end estimate values. Another testing method is post-mortem analysis, which has proven effective in generating more creative ideas about potential risks. Calibrated experts are the best source of data for probabilistic risk assessment methods.

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