As the price of gas starts to approach that of cheap wine, foreclosures hit a record, and companies find themselves unable to get the loans necessary to do business, I think again of portfolio theory in corporate risk management. I mentioned this a while back
as a response to an article by Nassim Nicholas Taleb, author of The Black Swan: The Impact of the Highly Improbable
. But today I started doing some rough calculations. One of the problems with complex mathematical models is that they have to simplify to make things easy for most people to understand.
However, sometimes there are simple calculations that can show you the potential folly of your ways. Assume for a second that in the financial world, there are, at any given time, 20 things that could go horribly wrong and wreak havoc. Say that the chance of any one of them occuring is only half a percent. Pretty low odds, right? Yes, for each given event, there is only a 0.5 percent chance in a year that it could happen. But remember that there are 20 of them, and because they are independent, they have a multiplicative effect. But 0.5 percent chance of going wrong is the same as 99.5 percent chance of going right. But when you multiple 99.5 percent by itself 20 times, you end up with about 90.5 percent. We've just gone from the psychology of safety in only a half percent chance of disaster to a more sobering 9.5 percent chance. Take that over a decade, and you see numbers that would make you bet the financial world would implode to some degree.
You can quibble with the percentages, or the number of disaster factors, even though I'd say I'm being pretty reasonable. So change some of the percentages, or the number of disaster scenarios. You're still left with the fact that, over time, the world will periodically drive itself into a brick wall at high speed.
I remember interviewing ChevronTexaco CEO David O'Reilly a few years ago. At one point I asked about geopolitical factors, as those are a problem in the oil business. He said that over time, there's always
some war or political unrest that affects their business. The company just assumes there will be one at any given time and figure out how to live with it. If more companies should take that attitude, the world might be in far more secure shape.
Labels: finance, management, portfolio, risk