Risk Tolerance in Non-Financial Contexts


/ November 13th, 2011/ Posted in Uncategorized / 3 Comments »

risk-toleranceDefinitions of risk tolerance can border on the absurd, showing a slavish adoption of financial terminology where it makes no sense.

The degree of risk tolerance, whether at the individual or organizational level, describes whether you are relatively:
1) risk-averse (risk avoiding) in exchange for a degree of certainty regarding the reward in question; or
2) risk-seeking, (accepting of risk) in exchange for the chance of higher gains.
These orientations towards uncertainty can be expressed quantitatively and qualitatively.

For example, financial advisors attempt to gauge an individual’s “investor profile” (tolerance for risk) in two aspects:
a) mental attitude towards risk (converted to a level) using a questionnaire; and
b) financial position, using a calculator.

Similarly, investment fund managers:
a) describe the strategy of a fund as relatively aggressive (risk-seeking) or conservative (risk-averse); and
b) have internal limits (risk appetite) dictating how much capital they will risk.

Therefore, risk tolerance might be articulated by: 1. a general characterization of attitude or philosophy, based on goals and values; and 2. corresponding measures of degrees of resource allocation and investment.

Levels of investment against anticipated return are controllable. Estimates of Economic Capital and liquidity to meet solvency requirements are calculable. Here, corporate statements of risk tolerance and appetite as specific numbers make sense. But translating risk tolerance to non-financial domains is sometimes done literally and inappropriately. Because of the rhetoric, health care and other public sector agencies feel pressured to define a positive number indicating, absurdly,  “tolerance” for children at risk, waitlisted patients, or traffic deaths. Some want to assign a dollar value to human life. Then again, declaring “zero tolerance” implies a strict attitude to abhor and punish one or another social ill, but, of course, cannot confer unlimited capacity to prevent it. The reality of outcomes is complex, and policy is made through a (hopefully fair) process of representations, reconciliations, checks and balances.

A statement of risk tolerance can be made in any organization, public or private, recognizing 1) the need for a qualitative definition; and 2) the possibility – when appropriate – for dollar values and verifiable measures.

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3Comments

  1. Davyd
    2014/04/18 at 04:52:43

    Despite the age of this post, the inanity of ‘risk tolerance’ wrongly applied abounds.
    I was in an ERM workshop hosted by a big name accounting/consulting firm a little while ago for my organisation, which is a major player in human/social services.
    The juvenescent facilitator asked us, without batting an eye, what our ‘risk tolerance’. What did she mean? How many deaths we’d ‘tolerate’? How many instances of child abuse we were happy not to detect?
    Inane was the only word. Or did she think that we could hedge the downside of human services by promoting more births to make up for the deaths that we ‘tolerated’?
    The workshop went down hill from there. We waded through the rote exercise of dreaming up a list of risks then giving them the vectors of probability of occurrence and cost and finally performing the mathematical magic of multiplying the vectors to get a scalar result! Still, they were only accountants, I guess.
    The whole thing was unstructured. No one gives a ‘risk tolerance’ off the cuff. It requires, where it is a relevant concept, research into the exposure and hedging that the company has and uses. Similarly for risk in business; it requires a deep understanding of the business strategy, delivery channels and resources, stakeholders and interactions points…research is necessary…just dreaming up risks in an unstructured format is a recipe for self-delusion.

  2. Edward
    2012/02/19 at 10:06:40

    Hi Dave,

    When you say Canadian cities, I assume you mean municipal / local governments. The answer “practically non-existent” could be right, but I don’t know of any surveys or articles that address this. You would have to do a database search.

    The first problem is one of definitions. Some organizations use the term “Enterprise Risk Management” — and yet do different things. Others, especially in government, use “integrated risk management”. I have seen “college-wide risk management”. And programs using just “risk management” could have fairly progressive practices. It is the same problem when trying to assess the extent of ERM in private corporations.

    Another way to approach the problem is to call the risk management department in major cities, and do a sort of informal survey.

    Edward

  3. Dave
    2012/02/18 at 23:51:08

    Hi Edward,

    I’m a student at a Canadian university looking to find how prevalent ERM is in Canadian cities. I was told they are practically non-existent. Can you please email me where you think I can find academic literature online that proves this?

    Thanks

    Dave

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