Report Defines the 'Art of Risk Management'

(November 19, 2011) — A recent paper by Thomas Coleman titled “A Practical Guide to Risk Management” asserts that the art of risk management among financial institutions is not about minimizing risk, but about harnessing opportunities: controlling the downside and exploiting the upside.

The central theme he highlights is that “in reality, risk management is as much the art of managing people, processes, and institutions as it is the science of measuring and quantifying risk.” The paper — published by the Research Foundation of CFA Institute, a not-for-profit organization, asserts that “human intuition is not very good at working with randomness and probabilities.” Therefore, to be successful at managing risk — which he believes is solely the responsibility of senior management — he suggests, “We must give up any illusion that there is certainty in this world and embrace the future as fluid, changeable, and contingent.”

Coleman concludes that risk management is about setting incentives and implementing good governance. “Managing people means thinking carefully about incentives and compensation. Although I do not pretend to have the answers for personnel or incentive structures, I do want to emphasize the importance of compensation and incentive schemes for managing risk and building a robust organization that can withstand the inevitable buffeting by the winds of fortune,” Coleman writes. 

According to the author, who currently manages a risk advisory consulting firm and was previously head of Quantitative Analysis and Risk Control at Moore Capital Management, there are four characteristics of situations that can lead to risk management mistakes: 1) familiarity, 2) commitment, 3) the herding instinct, and 4) belief inertia. Therefore, he asserts that risk management “is also about managing ourselves—managing our ego, our arrogance, our stubbornness, our mistakes. It is not about fancy quantitative techniques but about making good decisions in the face of uncertainty, scanty information, and competing demands.” 

Click here to see a video of Leslie Rahl, founder and managing partner of Capital Market Risk Advisors, speaking with aiCIO on her work in risk management and risk governance while urging portfolio managers to avoid mistakes of the past.