Minimising risk: Why it’s all about the numbers
The newspapers have recently been full of risky talk: the risk of bankruptcy as a result of recession, the risks to businesses from banks not lending money, the notorious risks taken by fund managers which resulted in huge losses to their investment bank employers. But quantitative methods could revolutionise the way managers deal with risk.
The word ‘risk’ is everywhere, and the recent turbulence in the global economy has also brought a discipline known as “quantitative risk management (QRM)” firmly into the business zeitgeist.
For many small to medium-sized companies, QRM was until recently something of a dark art. For the uninitiated, quantitative risk analysis (QRA) or QRM is actually nothing more than looking into the risks facing a business, putting some numbers on them to calculate their impact, and then mitigating or allowing sufficient contingency if things go wrong.
There are many parts of a business which can benefit from risk analysis: cost estimation, budgeting, cashflow forecasting, operational risk assessments, sales forecasting – in fact any part of a business where there is uncertainty.
Traditional QRM solutions tended to be expensive, enterprise-based applications targeted at large companies who were prepared to spend considerable time, money and human resources on an all-singing and all-dancing product which often ended up underused due to confusion on the part of the employees who were supposed to make it work.
However, steady increases in computer processing have given the desktops of today as much power as the high-end servers of a few years ago, meaning that risk analysis and management is now accessible for companies of all sizes.
Palisade’s @RISK software is one such desktop risk analysis tool and its Managing Director, Craig Ferri, feels that part of the reason for its success is that the product works in Microsoft Excel, a program found on virtually every workplace computer in the UK.
Using a technique called “Monte Carlo Simulation” (which was originally conceived by scientists working to develop the atomic bomb as part of the Manhattan Project) @RISK allows users to introduce uncertainty into their previously static spreadsheets, enabling them to look at things in a probabilistic, rather than a deterministic, way.
“In layman’s terms, this means that rather than companies and individuals making decisions based estimates or best guesses, they can see all of the potential outcomes to a venture – and also how likely these scenarios are to occur,” says Ferri.
For many companies this represents a real improvement to the decision-making process, he believes.
For the first time, employees have a tool which allows them to communicate their recommendations to management or colleagues in a transparent way with statements such as: “If we go ahead with this project there is a 75% probability that profits will exceed £500,000 and a 95% probability that they will exceed £300,000”.
This is a new type of language in the workplace, and now that QRM is being taught to a new generation of managers on most MBA programs, it’s a language that is here to stay.