Risk Management: Foundations for a Changing Financial World

CHAPTER 43

A BEHAVIORAL PERSPECTIVE ON RISK MANAGEMENT^aq

Andrew W. Lo

Traditional risk management approaches emphasize statistical and economic considerations. But comprehensive financial risk management should also incorporate the role of human preferences in rational decision making under risk.

Since the market turmoil of August and September 1998, skepticism has undoubtedly increased about the relevance of quantitative techniques for the practice of risk management. If, as most industry experts now acknowledge, the general “flight to quality” and subsequent widening of credit spreads was unprecedented and, therefore, unforecastable, what good are Value-at-Risk measures that are based on the statistics of historical data? These concerns are well-founded but somewhat misplaced in their focus. The fault lies not in the methods but, rather, in the unrealistic expectations we have in their application.

In a broader context, rational decision making under uncertainty requires a focus on three specific components, which I have previously described as the “three P’s of total risk management”: prices, probabilities, and preferences.¹ Although any complete risk management protocol should contain elements of all three P’s, to date most risk management practices have focused primarily on prices and probabilities, with almost no attention to preferences. In this article, I will emphasize the role of preferences in rational decision making under risk through three illustrative examples: ...