Risky Business with Brian Hughes
To discuss risk is risky in itself. Risk means different things to different people. In my experience as a root cause analysis investigator and instructor, discussion of risk generally is limited to only the negative possibilities. For instance, we discuss the risk that someone could have been in the vicinity of an explosion or the risk that a quality escape will lead to a cancelled contract. Risk in this context represents an attempt to calculate the chance that something bad will occur. We do this by looking at the probability that an event will occur along with the potential severity of the event. Usually there is a curve associated with this relationship between probability and severity – there is a lower likelihood of a catastrophic event occurring versus an event that is still characterized as undesirable, yet not quite catastrophic.
Risk analysis is interesting to me because it attempts to understand a range of possible outcomes through their probability and severity. It’s the study of what is most likely to occur based upon what’s already happened. But what interests me about it the most is the fact that we can calculate the likelihood of an event occurring… but with all the complex modeling available to us, the future remains a black curtain that only reveals itself in the present moment.
I studied Finance in college. Sure, I’ll admit to experiencing a little “Engineering envy” at times. Who wouldn’t want to design aerospace components or chemical processes? Luckily for me, there is some crossover – at it’s heart, Financial engineering requires that different sources of financing be identified, their relative costs compared, and how combinations of financing options combine to most closely meet the capital requirements of an individual or firm. But pricing various financial instruments (a necessary step in comparing costs) involves assessing their relative risks.
So what? you say. What does this have to do with the kinds of risks we experience in quality, reliability, safety, or other disciplines? Read on…
Financial experts consider risk a little differently than most Engineers. While engineering risk generally looks only at the chance that something negative will occur, financial risk looks at the chance that something will be different from expected – positive or negative. Daytraders don’t care about the underlying value of any individual financial instrument – they only care about volatility. If an asset price is predictably volatile, they have a good chance at making money on price swings. While you and I wouldn’t want this asset anywhere near our retirement fund as a standalone investment, the daytrader wants to try to buy it in the dip in the morning, and sell it a few hours later in an upswing. They are in and out, so even though their exposure is 100%, it’s only for a short amount of time. Volatility is something that is rarely addressed in assessing engineering risk. It’s here that we’re missing an important opportunity.
Financial risk is assessed via two components: Systematic and Unsystematic risk. The total risk of any asset is a combination of these two components.
Systematic risk is the background risk to which all players in a given industry are subject. For instance, all financial institutions are subject to the same level of Systematic risk. Hence, they are all in trouble right now… because very few of them properly assessed the changes in the levels of Systematic risk to which they were exposed. These changes included loaning money to risky individuals, transfer of risk through credit default swaps, creating mortgage backed securities from loan pools, etc ad nauseam (by the way a super article on this whole crazy mess can be found here).
The point is that since they were all subject to this systematic risk, they were all essentially skiing on the same unstable slope. All it took was one action to set the whole thing in motion. Some got buried by the avalanche… some managed to swim on top of it. All of us are paying a huge price though.
Unsystematic risk is the individual risk of a firm in any given industry. For instance, you could argue (successfully) that the reason Chase, Bank of America, and Wells Fargo are still around is because they carried less unsystematic risk than Wachovia, Washington Mutual, and Lehman Brothers. The same is true in any industry. Comparing Boeing Integrated Defense Systems with Northrop Grumman, Lockheed Martin, and Raytheon would require assessing the Systematic risk of the defense industry, using it as a baseline, and then assessing the unsystematic risk for each individual. It’s the Unsystematic risk that sets them apart.
Okay – finally to the point…
When we build an Apollo Cause and Effect Chart, we can see both these risks in the form of Action causes and Conditional causes. Many Actions (certainly not all) are associated with people. As such, people represent the Unsystematic risk component. Conditions are generally associated with the environment… the factory, the equipment, the part, the product, etc. Since the environment remains relatively consistent – all individuals interact with the same basic environment – conditions usually represent the Systematic risk component. Putting the two together provides an assessment of total risk.
In our financial markets, the government’s role is to regulate the Systematic risk. Sometimes they are good at this – sometimes not. But when they are successful, they have an impact on all they players. When we conduct a root cause analysis, we want to help reduce the risk to everyone – not just a single individual. The only way to do this is to identify the Systematic risk components (conditional causes) and attack them. Doing this reduces the baseline level risk for everyone.
At 1,000 words, I’ve blown our blog word limit by about 500. (Sorry Cory!) The bottom line – risk is volatility… eliminate the conditional causes of volatility and you will minimize the risk in the system.
Brian Hughes | Vice President
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