E1FFIRS 03/03/2009 9:34: 512 E1FFIRS 03/03/2009 9:34: 511 The Failure of Risk Management E1FFIRS 03/03/2009 9:34: 512 E1FFIRS 03/03/2009 9:34: 513 The Failure of Risk Management: Why It’s Broken and How to Fix It Douglas W. Hubbard John Wiley & Sons, Inc. E1FFIRS 03/03/2009 9:34: 524 Copyright#2009byDouglasW.Hubbard.Allrightsreserved. PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey. PublishedsimultaneouslyinCanada. 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FormoreinformationaboutWileyproducts,visitourwebsiteatwww.wiley.com. LibraryofCongressCataloging-in-PublicationData Hubbard,DouglasW.,1962- Thefailureofriskmanagement:whyit’sbrokenandhowtofixit/DouglasW.Hubbard. p.cm. Includesbibliographicalreferencesandindex. ISBN978-0-470-38795-5(cloth) 1. Riskmanagement. I. Title. HD61.H762009 658.1505–dc22 2008052147 PrintedintheUnitedStatesofAmerica 10987654321 E1FFIRS 03/03/2009 9:34: 525 I dedicate this book to my entire support staff: my wife, Janet, and our children, Evan, Madeleine, and Steven. E1FFIRS 03/03/2009 9:34: 526 E1FTOC 03/10/2009 15:4: 397 & Contents Preface xi Acknowledgments xv PARTONE AN INTRODUCTIONTO THECRISIS 1 CHAPTER1 Healthy Skepticism for Risk Management 3 CommonMode Failure 4 What Counts asRisk Management 8 Anecdote:The Risk ofOutsourcingDrug Manufacturing 11 What Failure Means 16 Scope and Objectivesof This Book 18 CHAPTER2 Risk Management:A Very ShortIntroduction to Where We’ve Been and Where(We Think) We Are 21 TheEntire History ofRisk Management (in 800 Words or Less) 22 Methods ofAssessing Risks 24 Risk Mitigation 26 TheState ofRisk Management According toSurveys 31 CHAPTER3 HowDo We Know What Works? 37 An Assessment ofSelf-Assessments 37 Potential Objective Evaluations ofRisk Management 42 What WeMay Find 49 PARTTWO WHY IT’SBROKEN 53 CHAPTER4 The ‘‘Four Horsemen’’ of Risk Management: Some (Mostly)SincereAttempts to Prevent anApocalypse 55 Actuaries 57 War Quants:HowWorld War II Changed Risk Analysis Forever 59 vii E1FTOC 03/10/2009 15:4: 398 viii contents Economists 63 Management Consulting:Howa Power Tieand a Good Pitch ChangedRisk Management 68 Comparingthe Horsemen 74 Major Risk Management Problemsto BeAddressed 76 CHAPTER5 An Ivory Tower ofBabel: Fixing the Confusionabout Risk 79 TheFrankKnightDefinition 81 Risk asVolatility 84 A Construction Engineering Definition 86 Risk asExpected Loss 86 Risk asa Good Thing 88 Risk Analysis and Risk Management versusDecision Analysis 90 Enriching the Lexicon 91 CHAPTER6 The Limitsof Expert Knowledge: WhyWe Don’t Know What We Think We Knowabout Uncertainty 95 TheRight Stuff: How a Group ofPsychologists Saved Risk Analysis 97 Mental Math: Why WeShouldn’t Trustthe Numbers inOur Heads 99 ‘‘Catastrophic’’Overconfidence 102 TheMindof ‘‘Aces’’: Possible Causes and Consequences of Overconfidence 107 Inconsistenciesand Artifacts:WhatShouldn’t MatterDoes 111 Answers toCalibration Tests 115 CHAPTER7 Worse ThanUseless:The Most Popular Risk Assessment Method and Why ItDoesn’tWork 117 A Basic Course inScoring Methods (Actually, It’s the AdvancedCourse, Too—There’s Not Much to Know) 118 Does That Come in‘‘Medium’’?:Why Ambiguity Does Not Offset Uncertainty 123 Unintended EffectsofScales: What YouDon’t Know Can Hurt You 130 Clarification ofScoresand Preferences: Different but Similar-Sounding Methods and Similar but Different-Sounding Methods 135 CHAPTER8 Black Swans, Red Herrings, and Invisible Dragons: Overcoming Conceptual Obstacles to Improved Risk Management 145