The dangers in making assumptions for risk management.
We’re told from an early age that to assume can make a you-know-what out of you and me. But the truth is that none of us could function in life or in business without basing our actions on myriad assumptions. Assumptions, in fact, are crucial to risk management.
The real question is whether those assumptions are well-founded. Too often, decision-makers fail to critically examine the premises behind recommended courses of action. As one retired general is reported to have said, “Amateurs study the plan; professionals study the assumptions.”
One professional—Paul Willen, senior economist and policy advisor with the Boston Federal Reserve—has studied the assumptions made in 2005 by investment banks that securitized subprime mortgages. Surprisingly, analysts did correctly predict the rate at which foreclosures would skyrocket if property values plunged, Willen said at a Federal Reserve System presentation on the subprime debacle. In that sense, investors had been alerted to the risky nature of these mortgage-backed securities. But significantly, the analysts had assumed only a 5 percent chance of a housing market meltdown.
What lay behind that assumption is noteworthy. The investment report stated: “House prices have never gone down since 1972,” said Willen, adding wryly that someone should explain to the analyst the difference between “never” and “since 1972.”
The meltdown scenario clearly revealed the highly risky quality of the securities, but the perceived remote likelihood of that eventuality made investors disregard the risk. We seem almost genetically incapable of processing how to handle this type of high-consequence, low-probability exposure, so we ignore it.
Overcoming our innate tendency to disregard remote risks is the principal challenge for homeland security. Department of Homeland Security Secretary Michael Chertoff addressed this point last year in a speech on the threat of a biological attack.
Chertoff noted that the medical community has vigorously opposed his plan to widely distribute medical kits with CIPRO. His objective is to ensure that, in the event of an anthrax attack, those exposed won’t need to go to a medical facility to obtain the antibiotic treatment.
“Many people in the public health community fight tooth and nail against this initiative because they believe we shouldn’t be focused on a remote possibility with a high consequence,” said Chertoff. The healthcare community worries about the more common risk of antibiotics being overused, not about the risk of a biological attack. But, said Chertoff, their argument “will be very unpersuasive the day there’s a massive anthrax attack.”
The mistake people make is to equate low risk with no risk. But that’s an assumption based only on wishful thinking. Instead, we should treat all risk seriously and ensure against it. After the fact, as we are seeing in the financial crisis, it’s exponentially harder to change course and contain the consequences.