ABSTRACT
Asset management is inherently a risk based decision making process. Practitioners in asset management are more inclined to consider uncertainty relating to a course of action than perhaps many other professionals, normally because their training and experience biases them towards structured approaches and avoidance of an unplanned outcome. But practitioners are also unlikely to embrace formal risk management procedures, often because the existing frameworks are overly prescriptive and can direct risk thinking to ‘slices of risk’ rather than the whole pie.
This paper challenges the distinctions between risk management as an empirically formal procedure-based discipline, and risk management as an intuitive practice, with respect to asset management functions.
Introduction
Asset management is inherently a risk based decision making process. Practitioners in asset management are more inclined to consider uncertainty relating to a course of action than perhaps many other professionals, normally because their training and experience biases them towards structured approaches and avoidance of an unplanned outcome. But highly developed practitioners are less likely to embrace formal, structured risk management procedures, often because the existing frameworks are overly prescriptive and can direct risk thinking to ‘slices of risk’ rather than the whole pie.
Asset management and risk management are two sides of the same coin
The practice of asset management requires a well developed sense of the potential for impending failure. Asset managers must be vigilant towards indicators of failure, whether they are overt – in the form of signals, alarms or reports – or not. Hence, asset management is essentially a risk management discipline, applied in context to the physical assets at an organisation’s disposal.
Asset management frameworks, procedures and standards such as PAS 55 and the emerging ISO55000 series draw on similar risk management documents in the same genre. Take the PAS 55 approach as an example: an essential part of the overall approach is the all hazards risk assessment process – identify, analyse, evaluate and treat the risk. Risk management is a key concept in the ISO55000 drafts.
Asset managers are responsible for managing risk
Regardless of the degree of formality around an asset manager’s role within an organisation, the manager of physical assets is at least responsible for assessing the risk of failure of those assets. This obviously includes determining strategies and actions to mitigate or treat an impending failure.
How does an asset manager go about reducing risk? Through increased awareness, transparency and consistency in the identification, quantification, reporting and control of asset related risks. This is a key element to value realisation – the organisation benefits from reducing financial losses, improving safety and minimizing environmental impact.
Risk management is as much about culture and behaviours as it is about process
Organisations that own or operate physical assets and intend to minimise the risks attributable to those assets will typically have well-developed control systems. Policy, procedure and guidance will be documented, and the performance of the business at managing risk may be monitored. The organisation will have empirical or tangible discipline in the form of documented process describing ‘normal’ responses to situations.
Really good operators in asset-intensive industries might also have a strong ‘risk aware’ culture, evidenced by collective behaviours and concern for risk. The emotional connections in such organisations contribute to the preservation of value for the organisation.
The culture of the risk aware organisation is influenced by the experience of how things are done, what is valued and not valued. Intangible aspects of this experience (such as symbols, norms, values) are underpinned by tangible aspects (such as processes, behaviours, systems). A risk aware organisation is characterised by people with a chronic pre-disposition towards avoiding uncontrolled or undesired outcomes.
Concepts of mindfulness and risk awareness
Let’s look at an example of risk awareness in safety critical industries.
Andrew Hopkins, noted Australian author of several books commenting on process safety, points to the culture and behaviour of asset intensive organisations as a contributing factor in preventing disasters. In analysing the causes of disasters such as the Texas BP Refinery explosion, Professor Hopkins suggests that ‘mindfulness’, which is a pre-occupation with the potential for and consequences of safety risks, characterises the good organisations.
‘Mindfulness’ can also be described as conscious risk aversion – a state of thinking and operating we are all familiar with when entering the casino.
Asset managers who are actively mindful of the risks of failure of their asset will have adopted a these behaviours. But they will also be displaying a certain level of intelligence about the environment they operate in. They will be concerned by the factors affecting the ability of their assets to achieve whatever business goals have been set and, most importantly, the drivers of failure that may create the potential for harm.
The elevation of behaviours that is conscious and sub-conscious, intuitive yet also highly structured and disciplined around repeatable process, leads to a level of mindfulness also described as risk intelligence.
Risk intelligent organisations are characterised by managers who adopt a chronic awareness of the risks
Risk intelligence generates awareness of risk at all levels within an integrated framework to obtain the best intelligence available under the circumstances. American economist and risk management author Frank Funston describes risk intelligence as an unconventional approach to risk management, because it challenges the conventions of management thinking about risk. According to Funston, too often we see organisations separating risk management from most strategic decisions and viewing risk in isolation from day to day business. Funston’s ‘unconventional risk intelligence’ approach is exemplified by people and organisations that acknowledge that factors affecting events will change and that not all things are equal. While events may appear mildly random, they could also be wildly random. This gives rise to a view that extreme events are more common than we might reasonably assume.
The discipline of asset management requires practitioners to be risk intelligent, but acceptance of this hypothesis is probably challenging in work environments reliant on formal structure and on repeatable process to fully prosecute risk-based asset management. While we can relate to documented frameworks, standards, plans and procedures, it’s a little more esoteric to describe our reliance on an asset manager ‘who knows his stuff’.
Skills of risk intelligence
However, we can identify the characteristics of risk intelligent organisations, and from that a skill set we would expect asset managers to demonstrate in performing their role. The ten risk intelligent skills suggested by Funston are:
- Challenging assumptions
- Maintaining constant vigilance
- Factoring in velocity and momentum
- Managing the key connections
- Anticipating causes of failure
- Verifying sources and corroborating information
- Maintaining a margin of safety
- Setting time horizons
- Taking enough of the right risks
- Sustaining operational discipline
These skills might not always be required for an asset manager role in all environments. But if we accept that asset management is essentially a risk management discipline, and that risk management is as much a behavioural science as it is empirical, then the degree of risk intelligence demonstrated by an asset manager must equip them better for their role.
Risk intelligence provides the basis for us to acknowledge the intuitive skill of experienced risk and asset managers who seem to know their stuff and apply it at the right times.
Risk intuition is an absolute fundamental for an organisation to achieve asset management excellence
What is risk intuition?
Theory about risk intuition is deeply rooted in the studies of economics and philosophy. In both fields, authors have attempted to describe the ability of humans to sub-consciously assess a situation, to make judgements, and to then form an action plan based on options. In the field of risk management, these activities are put to good use when gambling, which is why so many authors about economics and risk management theory have started their hypotheses with discussion about chance and games of dice.
Let’s consider some of the more popular definitions of intuition and its application to risk. Pareto described three types of intuition – one that leads to a proposition that can be verified, a second that is a false intuition where the proposition is not verified, and a third that leads to a proposition that cannot be verified. He makes the distinction in order to point out that intuition is valuable but fallible [1].
The acclaimed American economics theorist, Frank Knight, noted that the intuition of experts in the field under investigation is considered (more) worthwhile because it is based on experience’[2]. Knight was not alone in his views. Other economic theorists of the 20th century comment loosely on the fuzziness that is human behaviour in dealing with risk.
In the field of human sciences judgmental processes involved in risk perception and decision making have traditionally been conceptualized as cognitive in nature. One prevailing view put forward is that judgements are based upon a rational and deliberate evaluation of the alternatives at hand. However, decision researchers have looked beyond rational, deliberate, and cognitive processes and began to investigate intuitive (as opposed to deliberate) and emotional (as opposed to cognitive) aspects of decision making [3]. Böhm and Pfister looked at the role of anticipated emotions in the perception of risks that arise from the natural environment. They revealed that most emotions are socially constructed, and one of their primary functions is to regulate and coordinate social interactions — which most people master intuitively, for the better or for the worse.
The view of risk managers often presented in management texts as isolated rational decision makers is complemented by a view of them as decision makers and social beings who communicate with others and experience a wealth of diverse emotions when planning and coordinating their actions.
Risk intuition is both a rational trait, based on knowledge and experiences, and an emotional trait, based on perceptions of the impact of actions
Risk intuition is the ability to challenge assumptions, and to distinguish the ‘vital few’ from the ‘trivial many’, so the key is to focus on the key risks. In ‘Creating the risk intelligent enterprise’, Frank Funston refers to the skill of challenging assumptions, noting that this is a necessary starting point in considering risks and ways of addressing them [4].
In ‘The Black Swan’, Nassim Taleb describes the impact of highly improbable events, using the example of black swans, which Europeans in the 1600s believed did not exist [5]. Taleb suggests that experience can be misleading – just because you’ve never seen a black swan doesn’t mean there is no such thing. Experience leads people to form assumptions about what is probable or improbable, and possible or impossible. When the assumptions are wrong, the consequences can be fatal for those who are unprepared.
Risk intuition is therefore a result of:
- rational or hard experiences, which lead people to form assumptions about what is probable or improbable, and possible or impossible;
- exposures to unpredictable events with harmful consequences, which leads to a level of mindfulness and the pre-occupation with avoidance;
- emotional experiences, which people communicate and regulate in social interaction on an intuitive basis;
- an ingrained level of risk intelligence, which powers the unconventional approach towards challenging rational views, emotions and the evidence of previous exposure.
It is as much about the ability of a person to foresee a potentially hazardous situation, as it is to communicate it simply, and do something about it. The notion of intuition might be fascinating to psychiatrists and philosophers, but how is it relevant to risk and asset management? Let us apply these views of intuition to the discipline of risk management in asset intensive organisations.
The intuitive approach to risk and asset management
In seeking to understand how we might apply risk intelligence and risk intuition to the disciplines of asset management, let’s draw on some interesting definitions of management behaviour provided on the philosophy website Episteme [6]. (Note – Episteme exists almost entirely within the Wikipedia environment and is referred to here only for philosophical viewpoints of risk intuition).
Consider the following three approaches to risk management:
- Instinctive – may be characterised by a natural or innate impulse, inclination, or tendency.
- Intuitive – may be characterised by direct perception of truth, independent of any formal reasoning process.
- Empirical – may be based on, concerned with, or verifiable by, observation or experience rather than theory or pure logic.
The intuitive approach is probably taken least often by regular risk and asset management practitioners. It involves using data to support our decisions and justifications – those decisions and justifications that have already been made, given the experience of the risk or asset manager. The problem with this approach is that, by definition, it involves perception of truth, independent of any formal reasoning process. Executives and regulators alike would normally want to see, above all else, a reasoned, empirical process.
Absence of a reasoned process might influence intuitive risk management types to either regress to instinctive behaviours, or seek something else. Others might respond by taking on purely empirical approaches. What they could be doing is utilising their risk intuition more fully.
Risk intuition is a fundamental and accepted attribute of risk managers in the financial services sector. Consider the views expressed by Walter Haslett, noted British financial risk manager, about effective risk management of an investment. He suggests that all people involved in managing the investment must develop an intuitive sense of its performance numbers, such as real time and daily net asset values, and the variations possible, to be fully effective in their roles [7].
How do you create risk intelligence and risk intuition?
Bruce Schneier, a well known British commentator on security and risk, talks about people having a natural intuition about risk. It may fail at times due to a variety of cognitive biases, but for normal risks that people regularly encounter, it works surprisingly well, often better than we give it credit for [8].
Let’s relate this concept to a work environment. Co-workers often understand the risks better than a manager does. They know what the real risks are at work, and that they all revolve around not getting the job done. Those risks are real and tangible, and employees feel them all the time.
To create high levels of risk intuition behaviour, asset managers need to be encouraged to show risk intelligence. They need to be empowered to challenge both their own and others’ assumptions, to maintain a constant vigilance, and to be mindful of the potential for harm in all situations.
They should be allowed to be what they once were – trusting in their judgement, masters of their local universe, knowledgeable about all factors relevant to and affecting their assets, but with sufficient rational and emotional skills to judge what is significant, and what is not.
Conclusions
Asset management is inherently a risk-based decision making process. Risk is a key element in every aspect of the scope of asset management. Risk management underpins asset management standards, and must increasingly be demonstrated when procuring asset management services.
Practitioners in asset management are more inclined to consider uncertainty relating to a course of action than perhaps many other professionals, normally because their training and experience biases them towards structured approaches and avoidance of an unplanned outcome. Risk and asset managers are characterised by a disciplined approach to problem identification, to assessing options and to determining the right solution for a given set of circumstances. They are surrounded in this discipline by formal policy, guidelines, procedures and standards that all reflect a rational and conventional approach to their task. This formality constitutes an empirical approach, necessary as the foundation but not completely effective in an ever-changing workplace.
However, they may be less inclined to embrace formal risk management procedures if these are overly prescriptive and can direct risk thinking to ‘slices of risk’ rather than the whole pie. Faced with the ineffective formality of procedure, risk and asset managers in asset intensive organisations often adopt an unconventional approach to assessing a situation and making a judgement regarding the best course of action. Armed with more highly developed intuition and intelligence about the risks, people in these roles are better able to deliver the value-based outcomes demanded of operators of physical assets.
Risk intuition is an essential characteristic in good asset management. The pre-requisite skills of risk intelligence and organisational behaviours such as collective mindfulness, should and do contribute significantly to the effectiveness of asset management functions.
REFERENCES
1. Knight F, The limitations of scientific methods in economics, Selected Essays, University of Chicago Press, 1999
2. Knight F, Risk, uncertainty and profit, Harper and Row, New York, 1965
3. Böhm G and Brun W, Intuition and affect in risk perception and decision making, Faculty of Psychology, University of Bergen, Judgment and Decision Making, Vol. 3, No. 1, pp 1-4, January 2008
4. Funston F and Wagner S, Surviving and thriving in uncertainty – creating the risk intelligent enterprise, Wiley 2010
5. Taleb N N, The Black Swan: The impact of highly improbable events, Random House, 2007
6. Episteme, http://www.episteme.ca/cblog/index.php?/archives/54-Instinct-and-Intuition.html
7. Haslett W V, Risk management: foundations for a changing financial world, Wiley, September 2010
8. Schneier B, Risk Intuition, The Guardian, UK, 5th August 2009