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 guess 20,000 euros is a lot of money for you. A donation of EUR 20,000 would make your life much easier. Losing 20,000 EUR would make your life significantly more difficult. If you are a highly 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 over 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 EUR or nothing, both with a 50% probability, or a certain payout instead (100% probability). You are now risk averse if you prefer to take a payout of less than €1000 (for example €80) with a 100% probability of the bet, risk neutral if you are indifferent to the bet and a given payout of €100, lover risk (risk -prone) if it required the payment to be greater than EUR 100 (for example, EUR 120) to induce him to take the given 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 calculated risk-taking is imperative. 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 back and doing the same thing over and over again is probably enough to some extent, but for real growth risks must be taken and a culture of innovation must be fostered and nurtured. 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 direct-to-consumer model wouldn’t 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 does not mean 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 should be random. In most cases, that would be foolhardy 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 kinds of risks 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 reap the full potential benefits of information technology.
The global market sell-off has been partly attributed to hedge funds. Some argue, like the IMF’s Chief Economist on 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, buffer against market volatility and panic. If it weren’t for hedge funds covering short positions and buying cheap stocks, temporarily below price, the sell-off would be much worse. The performance fee forces managers to be risk averse. Like most real hedge fund managers, I hate risk and hedge everything 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 the 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 negative year for a fund almost guarantees the defection of key personnel and many investors, threatening, often fatally, the fund’s franchise. The administrator shares both disadvantages and advantages, so the incentive fee is nothing like a call option payment profile. A hedge fund MUST make money every year to be viable as a going concern.
People in greenhouses must not throw stones. Along with its equally incompetent sister, the World Bank, the IMF sadly demonstrates the wide gap between performance and incentives in its own woeful operations. IMF staff are highly paid and live in big houses in Washington DC, which nicely alleviates their own poverty and reduces the wealth of their unfortunate 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 local Citizen ex-college classmates from Macroeconomics 101 how their ” reforms and austerity measures will help ‘ordinary’ people A financial package is arranged, which often ends up in the elite’s offshore bank accounts and/or further ruins the economy/environment/people’s lives normal Good job MFI Good incentives
Hedge funds efficiently allocate capital where it can be best used. The bureaucratic economists of the IMF and the World Bank have spent the last 50 years inefficiently abusing capital and impoverishing poor people. Let’s compare their salaries to the incomes of the bottom 20% in client countries. It’s their job to alleviate poverty, so ENCOURAGE them to start doing it.