Book Review: Behavioral Risk Management

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Behavioral Risk Management: Managing the Psychology That Drives Decisions and Influences Operational Risk. 2016Hersh Shefrin.


In Behavioral Risk Management: Managing the Psychology That Drives Decisions and Influences Operational Risk, Hersh Shefrin seeks to enhance the observe of danger administration by serving to danger managers develop psychological expertise to enrich their quantitative expertise. Shefrin is the Mario L. Belotti Professor of Finance at Santa Clara University and a college member within the Master of Science in Risk Management program at New York University’s Stern School of Business. His guide Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing (Harvard Business School Press), printed in 2000, provided one of the first comprehensive treatments of behavioral finance and was intended for practitioners and academics alike.

Risk is mostly categorized into one among three spheres: market, credit score, or operational danger. Operational danger might be summarized as the chance of enterprise operations failing attributable to human error, and it contains dangers ensuing from breakdowns involving inside procedures, folks, and techniques. The creator analyzes the connection between behavioral psychology and operational danger, which garners the least focus by danger administration lecturers and practitioners.

Although market and credit score danger are the spheres that appeal to probably the most attention by lecturers and practitioners, among the most devastating danger administration failures in historical past resulted primarily from operational danger. An instance detailed within the guide is the excessively excessive aspirations — together with groupthink, extreme optimism, and overconfidence — that affected Fannie Mae, Freddie Mac, and AIG within the international monetary disaster. These psychological pitfalls (biases) on the highest ranges of administration have the potential to place chief government officers and chief funding officers in battle with chief danger officers.

Shefrin references numerous biases mentioned within the literature however focuses on solely a handful of them. He expounds at size on groupthink, which is the human tendency to not upset the established order regardless of an clearly inaccurate consensus. Bayesian avoidance, outlined as not updating the probabilistic judgments of danger as new info arrives, is one other bias that receives vital attention.

Shefrin offers tips on enhancing danger administration that construct on understanding, recognizing, and countering such biases. Debiasing strategies can cut back the frequency with which danger administration failures happen. They might be applied on an incremental, steady enchancment foundation. As assist for the significance of utilizing debiasing methods, the creator paperwork a number of main danger administration failures, most occurring after 2000, and predicts that severe failures will proceed to happen sooner or later. Organizational leaders ought to suppose long run by growing sturdy organizational cultures emphasizing danger administration processes and behaviors.

Shefrin favors utilizing a process-pitfall framework that builds on an idea generally known as open guide administration (OBM) to attenuate groupthink. The main processes central to OBM are requirements, planning, incentives, info sharing, and operations. Devil’s advocacy throughout the planning course of is inspired to problem assumptions. This cultural mindset begins with senior executives actively supporting debate throughout the firm and group leaders refraining from expressing their concepts till most group members have had a chance to precise opinions. Groups are particularly weak to groupthink after they depend on consensus and should not have preset guidelines and processes for choice making. OBM corporations additionally acknowledge that there’s a pure tendency for group members to chorus from sharing info. When teams are massive, OBM corporations use breakout periods with subgroups to interact in brainstorming earlier than the entire group convenes to debate a fancy concern.

The creator additionally describes RMP, which is a synthesis method to characterizing a corporation’s “risk management profile.” RMP was developed to measure the cultural strength of a corporation. As with OBM, making use of a danger administration course of to a corporation includes asking direct and particular questions. Organizational tradition is a medium via which danger drivers are remodeled into outcomes. Active satan’s advocacy is a vital facet of RMP as nicely and serves to mitigate groupthink. It induces group members to share info that they may be reluctant to reveal for concern of not showing to be supportive. Devil’s advocacy additionally mitigates polarization, whereby group dynamics amplify particular person members’ particular person danger tolerance profiles. Polarization happens as a result of in the middle of trying to assist different group members, some members set off a sequence response that generates magnification.

In abstract, Behavioral Risk Management is a thought-provoking guide that advances the behavioral finance literature by shifting past the historic give attention to asset pricing to look at operational danger inside a variety of establishments. The guide successfully demonstrates that funding managers want to grasp not solely the quantitative instruments, resembling conditional worth in danger, but in addition the psychology of danger administration.

More book reviews can be found on the CFA Institute website or within the Financial Analysts Journal.

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All posts are the opinion of the creator. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially replicate the views of CFA Institute or the creator’s employer.

Mark K. Bhasin, CFA

Mark Okay. Bhasin, CFA, is senior vice chairman of Basis Investment Group, LLC, New York City.

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