Oh what a tangled web we weave!
Frank
Ashe frank@quantstrat.com.au

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Risk analysis and management does not occur in a vacuum within an organisation -it is conducted in the milieu of that organisation's culture .
This culture determines the way in which the modelling task is perceived by both the modeller and the end user of the modelling results.
Perceptions differ , and this talk discusses why this difference can occur, how to mitigate the risk that arises, and some ideas on creating a better culture .
Case studies will be given from the presenter's experience, the Global Financial Crisis and
Public/Private Partnerships.

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Perception
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How do you and I notice things
Culture
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How do we notice things
What we do with things
Modelling
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Handling complex things
Risk Management
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Handling dangerous things

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How do you and I notice things?
Perception is noticing

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An individual’s perception is based on their past experience of a similar event, situation or activity;
People focus or pay attention to, different components (information) of the same situation;
Individuals have the ability to only process a limited number of facts and pieces of information at a time in order to make a judgment or decision concerning a certain activity, event, or situation;

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In general, it’s human nature to organize information so we can make sense of it
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We have a tendency to make new stimuli match with what we already understand and know about our environment

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A stimulus (impulse) that is not received by an individual person has no influence (effect) on their behavior while, the stimulus they believe to be authentic, even though factually inaccurate or unreal, will affect it;
Perception is the process by which each individual senses reality and arrives at a specific understanding, opinion, or viewpoint;

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What an individual believes he or she perceives may not truly exist;
A person’s behavior is based on their perception of what reality is, not necessarily on reality itself; and
Perception is an active process of decision making, which results in different people having rather different, even opposing, views of the same event, situation or activity.
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Ricciardi (2004) A Risk Perception Primer: A Narrative
Research Review of the Risk Perception Literature in
Behavioral Accounting and Behavioral Finance

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What is culture?
How do we perceive things?
What we do with things

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The way we do things 'round here
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Too simple, but effective
Beware of The Fallacy of Composition
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Organisations are different from the sum of the individuals
Culture governs what is perceived at an organisational level
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What does a company respond to?
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Speed of perception and speed of response
What does a company actively look for?
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What does a company believe is out there?

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Given a particular culture, are some things difficult to perceive?
Can some things not be talked about?
Are certain ideas not believed?

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How to handle complex things
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Thousands of models built into our perception systems by evolution – see optical illusions
Organisations build models of complex systems so they can think about them and act
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Inputs, outputs and assumptions are determined by the culture
So are techniques!

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A culture is not homogeneous
Does the user of the model share the knowledge and beliefs of the creator?
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How do you know?
Your own mind isn’t coherent, so how do you expect your organisation to be!

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Overoptimism – profit opportunities overestimated
Overconfidence – bad things won’t happen
Ambiguity aversion – avoid thinking about big uncertainties (disgust)
Availability bias – concentrate on things that are top of mind
Action bias – it’s better if we do something

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Dictum
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If you can’t measure it, you can’t manage it
WRONG !
What was Societe Generale’s estimate of losses from a rogue trader?
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Don’t need to measure this risk to manage it

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Inputs too good
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Averages too high
Standard deviations too low
Low probability of extreme events
Interpretation of outputs to fit beliefs
Ignoring negative outcomes

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Objectively low probabilities are made subjectively lower (1% = never)
Assume you can handle negative outcomes easily
Negative outcomes are a problem with the model

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Stochastic vs unknown
Processed by different brain centres
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What happens in an organisation?
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Initiative vs procedure
Is ambiguity avoided by a culture?
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“I don’t care if the model’s wrong, give me numbers so I can make a decision”
Don’t think about it
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Ignore it or defer it

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More notice taken of easily available things
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Model using more recent data
Past events associated with high emotion
Modelling using easily available data
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Easy to assume it’s relevant

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We must do something!
Modelling biased towards an action
Interpret the models to justify action
The effort of modelling may be seen to be wasted if action is not taken.
Modelled = understood
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Ambiguity aversion reduced

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Nothing new here, move along….
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Tone set by the top
Openness
Communication
Independent evaluation and review
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No! This does not mean your usual consultants
Tone set by the top (repeat as necessary)