Risk aversion means being willing to pay money to avoid playing a risky game, even when the expected value of the game is in your favor.
Let’s find out how risk-averse you are. If you are a student, I suppose that 20,000 euros is a lot of money for you. A donation of EUR 20,000 would make his life a lot easier. Losing 20,000 EUR would make your life noticeably more difficult. If you’re a high-paid executive or CEO (ha! ha!), multiply my dollar numbers by ten or a hundred.
Risk aversion is a concept in economics, finance and psychology that explains the behavior of consumers and investors under uncertainty. Risk aversion is a person’s reluctance to accept a deal with an uncertain payoff rather than another deal with a more certain but possibly lower expected payoff. The inverse of a person’s risk aversion is sometimes called risk tolerance.
A person is given a choice between a bet of receiving €200 or nothing, both with a probability of 50%, or instead, a certain payout (100% probability). You are now risk averse if you prefer to accept a payout of less than €1000 (e.g. €80) with a probability of 100% of the bet, risk neutral if you are indifferent to the bet and a given payout of €100, lover of the risk (risk-prone) if it required that the payment be greater than 100 EUR (for example, 120 EUR) to induce him to take the determined option on the bet.
The average payment of the bet, the expected value would be 100 euros. The certain amount accepted instead of the bet is called the certainty equivalent, the difference between this and the expected value is called the risk premium.
I firmly believe that for companies, whether in the technology sector or not, to enjoy long-term growth and success, a model that includes taking calculated risks is essential. In my opinion, about 10% of the projects a company pursues should be in the risk category. If a company is satisfied with organic growth, sitting down and doing the same thing over and over again is probably enough to some extent, but real growth requires taking risks and fostering and nurturing a culture of innovation. Too many companies become complacent or unwilling to upset the status quo.
Had that been the case, Wipro would still be Vegetable Products Ltd and not one of the world’s leading IT service providers. Dell’s model of direct-to-consumer sales would not have seen the light of day if Michael Dell hadn’t taken the risk. Ideas and concepts are not very useful if nothing is done about them. This is not to say that all potentially risky projects should be given the green light, or that all vegetable oil companies would prosper if they sought out IT services.
This is not to suggest that the risks must be random. In most cases, that would be reckless and counterproductive. Great leaders are those who learn to assess risks and can identify the right ones often enough. Managers and executives would do well to look at the types of risk some of the greats have taken and learn from them. IT is a high-risk profession, yet some organizations are reluctant to take reasonable levels of IT risk. When an organization is overly cautious in dealing with risk, it may not realize the full potential benefits of information technology.
The global market sell-off has been attributed in part to hedge funds. Some argue, like the IMF’s chief economist at Monetary Policy and Incentives, that incentive fees induce hedge funds to take more risk and that this is the cause of recent volatility.
This is simply wrong. Incentive fees incentivize hedge funds to MANAGE risk NOT to take risk. The two-month bear market (so far) is due to crowd overconfidence, central bank actions, and geopolitical effects on commodity prices. Hedge funds, if anything, cushion market volatility and panic. If it weren’t for hedge funds hedging short and buying cheap, temporarily below-priced securities, the liquidation would be much worse. The performance fee forces managers to be risk averse. Like most real hedge fund managers, I hate risk and hedge as much as I can; I benefit from volatility, but I certainly don’t cause it. Some of my strategies are based on buying in falling markets and selling in rising markets, while traditional investors do the opposite.
Some say incentive fees are unfair because the manager shares in the profits but not the losses. NO WAY. Real hedge fund managers ALWAYS keep their own money in their fund. A bad year for a fund almost guarantees the defection of key staff and many investors, threatening, often fatally, the fund’s franchise. The manager shares both the downsides and the upsides, so the incentive fee is nothing like a call option payout profile. A hedge fund MUST make money every year to be viable as an ongoing business.
People in greenhouses should not throw stones. Along with its equally incompetent sister, the World Bank, the IMF grimly demonstrates the vast gap between performance and incentives in its own woeful operations. IMF staff are paid high salaries and live in big Washington DC houses, pleasantly alleviating their own poverty and reducing the wealth of their hapless clients. IMF teams fly first class to impoverished countries, hang out in 5-star hotels with the local despot’s cousins (finance ministers and business “leaders”), and explain to their former college buddies local citizens of Macroeconomics 101 how their “reforms and austerity measures will help the ‘common’ people. A financial package is organized, often ending up in the offshore bank accounts of the elite and/or further ruining the economy/environment/life of the normal people good job IMF good incentives
Hedge funds efficiently allocate capital where it can be best used. Bureaucratic economists at the IMF and World Bank have spent the last 50 years inefficiently abusing capital and impoverishing poor people. Let’s compare their salaries with the income of the poorest 20% in client countries. It’s their job to alleviate poverty, so let’s ENCOURAGE them to start doing it.