The Essence of Risk

An Interview with Risk Management Expert Peter L. Bernstein

"Where organizations get blindsided is when something happens that is totally unexpected--and this is where communication and leadership take over."

Peter Bernstein graduated from Harvard College with a degree in economics, magna cum laude. After serving as a member of the research staff at the Federal Reserve Bank of New York and in a civilian capacity at the Office of Strategic Services in Washington, he joined the armed services and rose to the rank of captain in the Air Force in World War II. He taught economics for many years as an adjunct professor on the Graduate Faculty of the New School for Social Research in New York. In 1973 he launched Peter L. Bernstein, Inc. and became the first Editor of The Journal of Portfolio Management in 1974. He is now Consulting Editor of the Journal.

He is the author of nine books in economics and finance, plus countless articles in professional journals such as The Harvard Business Review and the Financial Analysts Journal, and in the popular press. He lectures widely throughout the United States and abroad on risk management, asset allocation, portfolio strategy, and market history.

Bernstein's book Against The Gods: The Remarkable Story of Risk won the Edwin G. Booz Prize for the most insightful, innovative management book published in 1996. In 1998, it was awarded the Clarence Arthur Kelp / Elizur Wright Memorial Award from The American Risk and Insurance Association (ARIA) as an outstanding original contribution to the literature of risk and insurance. The book has sold over 500,000 copies worldwide. Bernstein’s latest book is The Power of Gold: The History of an Obsession.

He spoke to the Journal of Business Strategy about the recognition and taming of risk.

What are the key points a professor of economics needs to impart to students for them to understand risk management?
First, students need to balance risks and probabilities. An example I refer to in Against the Gods is "Pascal's Wager." Pascal said, "Is there a God, or is there not a God?" How in the world can we answer that question? We can't reason it out so we can't really provide an answer to it. But we can still take a rational approach to addressing this issue. We can act as though there is a God, or we can act as though there is not a God.

Let's see how that would work out. If we act as though there is a God and the very end of everything comes and there's not, at least I lived a life of virtue, I passed up some goodies, but it was a pretty good life. On the other hand, if I act as though there's not a God and I lead a life of lust and sin and selfishness, and then when the end of my life comes, and I find out there is a God, I'm in big trouble! Therefore, in Pascal's view, a person can assess the consequences of this type of very important decision. A person can weigh the consequences of being wrong, and its probabilities, with the alternative course of action.

Likewise, students need to assess the probability of future events occurring, and the consequences if indeed they do occur. For example, the chances of a terrorist attack may be small, but the consequences are enormous. In the area of risk management, portfolio managers try to cover all the bases they can think of; they try to have a structure that will respond to the truly unexpected.

One positive example is how quickly after September 11th the New York Stock Exchange got back into business. The cataclysmic event of 9/11 occurred in their very backyard. The physical, as well mental and emotional connections, in the financial community were destroyed. And yet, the NYSE was able to get the market was back up and running in a week or so. Dick DeGrasso, then Chairman of the NYSE, although criticized for his enormous salary, deserves credit for leadership under these difficult circumstances.

Of the various points raised in Against the Gods, I would emphasize that an organization can prepare for events by instituting a system of communication and clear recognition of leadership responsibilities. It's easy to develop quantitative techniques for risk management; but those are for the risks that we know and understand. Where organizations get blindsided is when something happens that is totally unexpected-and this is where communication and leadership take over.

Second, students must realize that risk can never be eliminated entirely. One example relates to mathmetician and philosopher Gottfried Wilhelm Leibnitz. Leibnitz said nature is very consistent in repeating itself-but only for the most part. In other words, no model works 100 percent of the time and you have to be prepared for the unexpected. The real purpose of risk management systems is to be able to respond to the unexpected. It doesn't mean that it is all going to be bad. It may be an opportunity that drops into your lap. If you're not prepared to deal with it, you'll pass something up. But, no mechanical arrangement, no management committee, and so on, will eliminate risk. Each individual, family unit or company will have to develop its own comfort level with risk.

How much of understanding and assessing risk is based on technical analysis as opposed to other factors?
In Against the Gods I cite a statement by Elroy Dimson, BGI Professor of Investment Management at the London Business School: "Risk means more things can happen than will happen." It's a very fancy way of saying we don't know what is going to happen. But this is a way to think about risk. There is a range of outcomes out there and we don't even necessarily know how wide that range is. That's a generalization that applies to every feature of risk. I think you have to begin by thinking that way and then ask, "How can we respond to this?"

There are some risks that we know are in certain bounds. For example, we could say the temperature in the next year is going to range from a place between zero and a hundred. At the same time, the range is not going to be between minus one hundred and plus three hundred. A sound technical analysis will develop a reasonable range of outcomes. In general, we can develop a good sense of the range of possible outcomes, but the trick is how to prepare when things happen outside the range-and this is likely to happen all the time. I used to do a lot of very elaborate scenario forecasting in my stock market and investment work, but there was always another scenario that I had not thought of. And that unknown event could happen too. We have to acknowledge that there is a great unknown out there.

Is that a recipe for debilitating inertia?
We need to distinguish between situations where we have control over the outcome from those where we don't. On the one hand, in spite of risk, we can make decisions where we have some control over the outcome. If I'm running a company and I buy another and it doesn't work out the way I thought or if I start a new product and it doesn't work out the way I thought, there are things I can try to do to fix it. I'm not helpless in being caught by a surprise.

On the other hand, there are situations where I have no control over the outcome. If I buy 1,000 shares of General Motors hoping to make money, I have no control over the stock market. The stock market will reflect what other people are prepared to pay for my shares. So in this situation I have a different perspective. I can simply decide when to cut my losses or take my profits. As a result, in the above two scenarios a person approaches the element of risk differently.

In Against the Gods you state, "The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us." Was 9/11 random or predictable?
In hindsight, 9/11 was predictable in the sense that there is a great deal of militant animosity towards the U.S. In many parts of the world the U.S. isn't the great symbol of beauty and freedom that Americans like to think it is. Many people are deeply envious of our political and economic clout-and they have very little to lose in expressing their displeasure.

I recently read that South Koreans by way of poll agreed that if the US attacked North Korea, they would side with the North Koreans. This would be startling to most Americans given that the South Koreans have been our great allies for 50 years. In view of this type of commitment from our own allies, the actions of our adversaries should not be surprising.

The bottom line with respect to 9/11 is that the American leadership did not give enough attention to the scope and nature of risks through terrorist attacks on U.S. soil. The lesson with respect to risk management is that it is not easy to think outside the box. I don't know if we could have prevented 9/11, but at least when it happened we could more quickly grasped the grievances which propelled the motivation for this type of unprecedented attack.

What about articles that referred to past predictions about towers in the U.S. being attacked?
I have very recently finished writing a book called The Wedding of the Waters: The Erie Canal and the Making of a Great Nation. The hero of that story is De Witt Clinton, then governor of New York, who at great career and personal risk pushed ahead the Erie Canal project. This was a wildly innovative and unbelievably enormous undertaking. Clinton had a very weird sense of what the future held, a kind of a spooky ability to see things.

He gave a speech in 1810 to the New York Historical Society about the way people had treated the Indians on the continent of North America. He said if Americans go on like this there will be a day when some brilliant man arises in some Far East or Asian country and our cloud-capped towers will be knocked down. Who knows how he conceived that image, but it makes chills run through you.

He sensed that if Americans continued to mistreat people of color that there would be some terrible event of retribution. Americans by nature value success, bold action and a can-do attitude. De Witt Clinton's warning and the events of 9/11 teach us that we have to carefully assess the risks of our actions.

You state in your article titled, Are Policy Portfolios Obsolete, "we can have no assurance that history will replay itself in any shape, form, or sequence." Did that shake up the portfolio managers you were addressing?
My statement was simply another way of saying we don't know what the future holds. The heads move up and down, and the audience indicates that they agree with it. But their subsequent actions don't reflect agreement. Portfolio managers act with high confidence as though they know what the future holds. Their assumption is that if the stock market has given a 7 percent total return on average over the past 150 years, then this type of return is likely over the next 50 years.

My perspective of not viewing the past as a necessary predictor of the future is something I believe in like deep religion and it has influenced every decision I have made.

In USA Today you were quoted as saying, "Some people are addicted to seeing a catastrophe in the future." Does this mean that you think that they shouldn't?
One segment of portfolio managers are predictably negative. But the world economy is not like that-although some things get worse, other things get better. I have nothing more to learn from a one-sided perspective. I'm much more interested in somebody who is bearish on one occasion and bullish on another. Or somebody who will say, "I really was wrong...I think I have to change my mind and consider a new perspective."

Your publication Economics and Portfolio Strategy combines "the discipline of theoretical analysis and the practice of hands on portfolio management." Do you think that the practice and the theory are not interwoven enough?
I started in this business 50 years ago and I have always thought that theory and practice are more interwoven than people realize. The theoretical tools I acquired in college were very helpful to me when I launched my investment career.

I believe that theoretical ideas are very powerful and that one has to keep them in mind when trying to understand what is going on in the financial markets and in trying to develop actual strategies for portfolio management. A sound theoretical foundation is a starting point. A person may find reasons over time to depart from theoretical ideas, but if you don't begin there you're going to be lost in the woods very soon.

You were quoted in the Chicago Tribune as saying with respect to GM and Ford, "how the mighty have fallen, it's a very sad day." Does this mean that you identified something they could have done differently or is there something you pinpoint where they could have avoided the situation they are in to some extent today?
I was an early buyer of foreign cars back in the 1950s. I wanted a smaller car and something that handled differently than American cars. While Japanese auto manufacturers addressed consumer desires through high quality and low prices, and progressively increased their market share, American companies seemed to be stumbling along behind.

Yes, I believe the American auto manufacturers have created their own problems, and they have been in the making for quite some time. In addition, American auto manufacturers have the enormous employee benefit burden. These benefits were a boon to employees, but the costs have made American companies less competitive.

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Interview conducted in August, 2005 by Rick Goossen, Executive Editor.

Peter L. Bernstein Website

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