Downpour risk means being willing to pay money to avoid playing a risky game, even when the expected value of the game is in your favor.
Let’s find out how risky the downpours are. If you are a student, I suppose 20,000 euros is a lot of money for you. A gift of 20,000 euros would make your life much easier. Losing 20,000 euros would make life much more difficult. If you are a well-paid executive or CEO (Ha! Ha!), Multiply my dollar numbers by ten or by one hundred.
Risk aversion is a concept in economics, finance and psychology that explains the behavior of consumers and investors in situations of uncertainty. Risk aversion is a person’s reluctance to accept a deal with an uncertain reward rather than another deal with a more certain but possibly lower expected reward. The inverse of a person’s risk aversion is sometimes called risk tolerance.
A person can choose between a bet of receiving EUR200 or nothing, both with a probability of 50%, or instead, a specified payout (100% probability). You are now risk averse if you prefer to accept a payment of less than 1000 EUR (for example 80 EUR) with a 100% probability that the bet, risk neutral if you are indifferent between the bet and a certain payment of 100 EUR, lover of the risk (risk -proclive) if you required the payout to be more than EUR100 (eg EUR120) to induce you to take a certain option on the bet.
The average payout of the bet, the expected value would be 100 euros. The certain amount accepted in place of the bet is called the certainty equivalent, the difference between it and the expected value is called the risk premium.
I firmly believe that for companies, whether in the technology sector or otherwise, to enjoy long-term growth and success, a model that includes calculated risk taking is essential. In my opinion, around 10% of the projects that a company pursues should be in the risk category. If a company is satisfied with organic growth, sitting down and doing the same thing over and over will probably be enough to some extent, but for real growth risks must be taken and a culture of innovation must be fostered and nurtured. Too many companies become complacent or unwilling to alter the status quo.
Had that been the case, Wipro would still be Vegetable Products Ltd and not one of the leading IT service providers in the world. Dell’s model of direct-to-consumer sales would not have seen the light of day if Michael Dell hadn’t taken the risk. Ideas and concepts are not very useful if nothing is done about them. This does not mean that all potentially risky projects should get the green light, or that all vegetable oil companies would prosper by seeking IT services.
This does not suggest that the risks should be random. In most cases, that would be reckless and counterproductive. Great leaders are those who learn to assess risks and can identify the right ones often enough. Managers and executives would do well to look at the types of risk that some of the greats have taken and learn from them. IT is a high-risk profession, yet some organizations are reluctant to take reasonable levels of IT risk. When an organization is too cautious in addressing the issue of risk, it may not reap the full potential benefits of information technology.
The global market liquidation has been attributed in part to hedge funds. Some argue, like the IMF’s chief economist on Monetary Policy and Incentives, that incentive fees induce hedge funds to take more risks and that this is the cause of recent volatility.
This is simply wrong. Incentive fees incentivize hedge funds to MANAGE risk, NOT take risks. The two-month bear market (so far) is due to overconfidence from the single crowd, central bank actions, and geopolitical effects on commodity prices. Hedge funds, if anything, reduce market volatility and panic. If it weren’t for hedge funds hedging shorts and buying cheap securities, temporarily below price, the sell-off would be much worse. The performance fee forces managers to be risk averse. Like most real hedge fund managers, I loathe risk and hedge as much as I can; I benefit from volatility, but I certainly don’t cause it. Some of my strategies are based on buying in bear markets and selling in bull markets, while traditional investors do the opposite.
Some say that the incentive fees are unfair because the manager shares the profits but not the losses. NO WAY. Real hedge fund managers ALWAYS keep their own money in their fund. A negative year for a fund almost guarantees the defections of key personnel and many investors, threatening, often fatally, the fund’s franchise. The manager shares both the downsides and the gains, so the incentive fee does not act as a call option payment profile. A hedge fund MUST make money every year to be viable as a continuing business.
People in glass houses should not throw stones. Along with its equally incompetent sister, the World Bank, the IMF sadly demonstrates the wide gap between performance and incentives in its own woeful operations. IMF staff receive high salaries and live in large Washington, DC houses, which very well alleviates their own poverty while reducing the wealth of their unfortunate clients. IMF teams fly first class to impoverished countries, hang out in 5-star hotels with the local despot’s cousins (finance ministers and business “leaders”), and explain Macroeconomics 101 to their former colleagues at the local citizen college , on how his “reforms” and austerity measures will help “ordinary” people. A financial package is organized, which often ends up in the elite offshore bank accounts and / or further ruins the economy / environment / lives of normal people. Good job IMF. Good incentives.
Hedge funds efficiently allocate capital where it can be best used. Bureaucratic economists at the IMF and the World Bank have spent the past 50 years ineffectively abusing capital and impoverishing poor people. Let’s compare their salaries with the incomes of those in the poorest 20% of client countries. It is their job to alleviate poverty, so we ENCOURAGE them to start doing it.