Red-Blooded Risk: The Secret History of Wall Street

Principle V: Evolution

What are some examples of good risk? Evolution, for one. Random variation leads to more wonderful creations than anything any human ever designed on purpose. But there are two important caveats. Mutation is almost always bad for the individual, but the optimal amount is good for the population. However, the population is not fixed; it changes over time both in composition of individuals and in genetic characteristics. And a deeper look at evolution reveals that it operates on many levels, from individual selfish genes to (possibly) Gaia, the web of all life on Earth. So while the randomness can be good, we need to ask if it is good for the entities we care about.

The second caveat is that random variation is only half of evolution; the other half is natural selection. Suppose we are facing the classic corporate finance capital budgeting problem. We have a list of projects our company might pursue and we have to choose which ones will be accepted. In the classic formulation when faced with two projects of equal expected present value, we choose the less risky one. But risk creates diversity, which makes it more likely the company can survive unexpected events. Even better, the diverse company that has been refined by a series of crises will have evolved into a better-constructed entity, more fit for future challenges.

I intend to use scientific analogies like this to describe the remaining risk management principles. This form can be abused by taking a popular ...