Risk – What is it? Why is it Important?
The term “risk”, more so than many other technical terms, seems to cause a lot of confusion.
This might be due to the nature of the diverse array of disciplines in which risk arises – you can find risk popping up in discussions in engineering, reliability, economics, finance, actuarial science, environmental science, medicine, occupational safety, national security, cybersecurity, business, and project management (and probably many others). Given that disciplines of study tend to develop their own terminology, it is not surprising that different practitioners and researchers across (and sometimes within) fields tend to talk about risk in different ways. Another factor causing confusion comes from the colloquial uses of risk-related terminology in every-day language, such as “taking a risk” and “risking it all”.
Regardless of the source of the confusion, it is beneficial to understand the nature of risk. In life, business, or basically any human endeavor,
A) there are a lot of bad things that could happen,
B) but there is uncertainty about whether or not they will occur, and
C) if they do occur, one or more unpleasant consequences will be realized.
In fact, paralleling these considerations, the process of doing a risk assessment has been defined by Kaplan and Garrick (1) as answering the following three questions:
- What can happen? (i.e., what can go wrong?)
- How likely is it that that will happen?
- If it does happen, what are the consequences?
As an example, imagine Bob is painting an interior room of his house.
- What can go wrong: Bob could accidentally kick over the can of paint.
- How likely is it that that will happen: It is hard to say, but not very likely.
- If it does happen, what are the consequences: Bob ruins his carpet, which he has to replace (expensive), and he has to buy a new can of paint (not expensive).
Now imagine another scenario.
- What can go wrong: Bob could fall from a ladder, and in the process, accidentally knock over the can of paint.
- How likely is it that that will happen: Probably pretty unlikely.
- If it does happen, what are the consequences: Not only does Bob ruin the carpet and have to buy a new can of paint like before, but he also breaks his arm.
The second scenario clearly seems worse from a consequences standpoint. But which one is a greater risk?
Risk is classically defined as a measure of the probability and severity of an adverse event (2). Risk is therefore a metric which quantifies the expectation of loss or harm associated with an adverse event.
In our example above, we don’t have enough information to say which one is the greater risk. However, through a risk assessment, we would be able to estimate the probabilities of kicking over the can of paint and of falling off of a ladder, as well as to quantify the losses associated with installing new carpet, buying a new can of paint, and of medical bills related to Bob’s broken arm. When we have this information, we could compare the risks.
More importantly, even without quantifying everything, we can immediately begin to think of risk management actions. If Bob purchases a large tarp that covers the carpet, then the carpet will not be ruined if he knocks over the can of paint (although he still needs to buy new paint).
Or perhaps if Bob is extremely clumsy, and assesses his probability of spilling paint to be high, he might judge that it is worth it to hire professionals to paint the room for him instead of doing it himself. In this case, it is worth it to Bob to pay the painters a certain amount of money in order to avoid the potential losses of his falling off of the ladder, breaking his arm, and spilling paint everywhere. This is an example of how risks can factor into decision making.
Of course, real life presents many more sources of risk than illustrated here in this simple example. In fact, Kaplan and Garrick state that risk is inherent in all action: “In analyzing risk we are attempting to envision how the future will turn out if we undertake a certain course of action (or inaction).”(1) Therefore, there is a lot of value in being able to think clearly and systematically about risk.
At Collier Research Systems (www.collierresearchsystems.com), we can help clients think through what can go wrong, how likely it is, and what are the consequences to their strategy and objectives, as well as guide decision making related to effective risk management actions.
(1) Kaplan, S., and Garrick, B.J. 1981. “On the quantitative definition of risk.” Risk Analysis, 1(1), 11-27.
(2) Lowrance, W.W. 1976. Of Acceptable Risk: Science and the Determination of Safety. William Kaufman Inc.