To understand risk management, look to heuristics

To understand risk management, look to heuristics

From the Bible to Bagehot, heuristics have been central to risk management culture. The 21st century science of risk management needs to work hand-in-hand with the age-old art of heuristics.

Heuristics— rules of thumb developed through experience— were the first effective risk management tools. So fundamental were they throughout history that they found expression in some of culture’s highest creations.  Reference to diversification heuristics can be found in ancient religious texts, such as the Talmud and Ecclesiastes, and in Shakespeare’s plays and poetry. Antonio comments in The Merchant of Venice:

My ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year.

Credit risk is addressed in Hamlet, when Polonius advises his son, “Neither a borrower nor a lender be.”

Perhaps the most practical heuristic is that created by Walter Bagehot in 1873. As the publication he founded, The Economist, describes his heuristic for managing financial panics, central banks should lend “quickly, freely and readily,” at a penalty rate of interest, to any bank that can offer “good securities” as collateral.

From art to science, and back to art

Early managers found value in heuristics for dealing with the risks and uncertainties they encountered daily. By contrast, actuarial methods are fairly recent innovations, having been developed since the 16th century. Advanced quantitative methods were available only after the gradual evolution of mathematical methods and the rapid advent of computer technologies since the middle of the 20th century.

Modern methods of risk management became so dominant that heuristics were supplanted by statistical models and computer simulations.  Risk management today is practiced largely as a quantitative function best understood by quants and engineers. Modern risk management is a science, not an art.

For present-day risk management to be effective, managers need to resurrect the use of heuristics to complement their quantitative methods.  Much useful information necessary for the effective management of risks exists only at non-managerial levels. This information is not immediately available to corporate risk managers.

Many risks can be managed most effectively by lower-level staff. In 1955, Toyota line workers were given ownership of quality control with the ability to halt production lines to prevent passing along defective parts. This ownership (Jidoka)is a “main pillar” of the Toyota Production System.

As Frank Knight pointed out in 1921, most risk management problems are ill-structured problems. Heuristics evolved to deal with just such problems and so are particularly well suited to solving them.

Over 35 years later, Herbert A. Simon and Allen Newell made a similar argument, updating it to accommodate technological advances. They wrote in Operations Research in 1958, “With recent development in our understanding of heuristic processes and their simulation by digital computers, the way is open to deal scientifically with ill-structured problems.”

In accepting the Nobel Prize in Economics in 1978, Simon defined heuristics simply as “rules of thumb.” This simplicity lends heuristics their power to deal with complex situations such as risk and uncertainty. Simplicity allows heuristics to be used as risk management tools by staff at all levels within an organization.

Of dogs, Frisbees and trees

Citing Simon’s lessons, Andrew G. Haldane, Executive Director for Financial Stability at the Bank of England, wrote in 2012 that “it was precisely because humans operated in a complex environment that they sought such simple behavioural rules….(Heuristics) were evolutionary responses, honed in the light of experience.”

Heuristics are a powerful contribution to complex decision-making that can be mastered by anyone. Haldane illustrates the power of heuristics by pointing out how very difficult it is to catch a Frisbee. “Were a physicist to write down frisbee-catching as an optimal control problem” he would have to apply Newton’s Law of Gravity.

Yet dogs manage the task with joyful ease.  “So what is the secret of the dog’s success?” asks Haldane.  “Studies have shown that the frisbee-catching dog follows the simplest rules of thumb.”

Bank of England Financial Stability Paper No. 28 (May 2014) found that:

i. simple methods can sometimes dominate more complex modelling approaches;

ii. simple indicators…often outperform more complex metrics; and

iii. …’fast and frugal’ decision trees…can perform comparably to standard regression techniques, while being simpler and easier to communicate.

The great advantage heuristics offer over most quantitative risk

management methods is their simplicity of structure and user-friendliness. Used strategically, the simplicity of heuristic methods can complement the complexity of the quantitative approach. In addition, simple heuristics are often more appropriate and accurate methods to complex risk management environments than quantitative models, which they often outperform.

The Bank of England paper points out, “ever more complex models are impenetrable for most managers who nevertheless need to use them to make everyday decisions.” An example of a fast and frugal tree useful in financial risk management is depicted below.

The user-friendliness of heuristics recommends the method as a system for building risk literacy throughout an organization.  Staff at all levels can learn their use. The integration of lower-level staff into the risk management function can create value, as shown by the Toyota Production System.

Educating C-level executives, risk and audit committees and boards of directors in heuristic risk management tools would be beneficial as well and would strengthen their oversight abilities. Heuristics can form the foundation on which to build risk culture within an organization from the bottom up.


Categories: Finance, International

About Author

Steven Slezak

Steven is on the faculty at Cal Poly in San Luis Obispo, California, where he teaches finance and strategy. He taught financial management and financial mathematics at the Johns Hopkins University MBA program. He holds a degree in Foreign Service from Georgetown University and an MBA in Finance from JHU.