7 Deadly Sins – Overconfidence

Massimo Piatelli-Palmarini writes in his deliciously written book “Inevitable Illusions” about the 7 deadly sins of our cognitive illusions.

His first sin is overconfidence. This is where we feel certain about our knowledge of something, but our knowledge does not really warrant such confidence.

He describes experiments where subjects are asked to answer questions and then rate how confident they are about each answer.  Experiments show that our confidence leads our knowledge.

We think we know something more than we really know.

The results of the experiments also bring about something sobering: we are most overconfident in areas we are more knowledgeable about.  That is, the difference between the level of our overconfidence and knowledge in these areas is bigger than the difference between our level of overconfidence and knowledge in other areas - hence we tend to make mistakes of overconfidence in our areas of expertise.

On Issues Versus Risks

Whenever you find yourself in an introductory presentation on risk management, you can expect to hear a question like: “What’s the difference between an issue and a risk?” The expected answer seems to be always: “A risk is something that may or may happen, while an issue is something that has already happened.” 

Correct enough, but this description falls short of conveying any relationship between the two.

Here’s one I coined, I like, and plan to use and re-use: “Issues are the risks you failed to manage, now come to haunt you.”

The sentence makes clear that many of the issues that you face could have been mitigated if only you had done proper risk management.  The assertion is not always true of course.  Some issues just come from unpredictable circumstances, and no risk management is that perfect.  So surely,  there are exceptions, but the strong assertion of the sentence emphasises just that – that exceptions are the exception.

I believe I originally picked up this relationship from Bill Duncan.  A few years ago he quoted someone he knew who said that in a good risk management process, all the issues that arise will have been previously identified in the risk register.  So it’s not my original idea, but I like the “now come haunt you” bit, which is mine.

ISO 31000:2009 The Effect of Uncertainty on Objectives

For several weeks, I had been consumed with trying to understand what the new definition of risk really means.

As anyone involved in risk management knows, the ISO late last year published the new Risk Management Standard known as ISO/IEC 31000:2009.  One of the innovations in this standard is a new definition of risk -- a rather oddly phrased definition, in my view. The new definition says that risk is "the effect of uncertainty on objectives."

Clear as mud?  Compare that with the previous definition used by a de facto worldwide standard.  AS/NZS 4360:2004 defined risk as "the chance of something happening that will have an impact on objectives."  Here it’s clear that risk is clearly tied to "something happening".  Risk is an event or a circumstance (together with its chance of happening).

In the new ISO definition, risk is the "effect of uncertainty".  This is quite unfortunate because “uncertainty” is not about how things will happen, but is more about our state of knowledge.  Our lack of knowledge about how things will turn out.  Events will happen, we just don't know which and when.  Uncertainty is our ignorance.   Even ISO is aware of this, and notes that uncertainty is "the  state, even partial, of deficiency of information related to understanding or knowledge of an event, its consequence or likelihood."

If I replace this meaning of uncertainty in the definition of risk, we come up with:

• Risk = the effect of ignorance on objectives.

Clear as Florida swamp water.

But what about "effect"? What does this word mean? Well ISO 31000 defines effect as "a deviation from the expected -- positive or negative". So if we use that definition, and
insert it into the definition of risk, we get:

• Risk = the deviation from the expected, due to our ignorance, on objectives.

Which is now really realy murky.

An inadvertent clarifying light came last night while I was re-reading Elaine Hall's "Managing Risk: Methods for Software Systems Development".  Hall notes that risk is “potential loss.” Since potential means possible, which can be another definition of “uncertain” (not certain = possible = uncertain), and since I know the ISO 31000 wants to incorporate "positive risks" into the new definition of risk, then maybe ISO is trying to say that risk is "loss or gain on our objectives due to events which may occur".

If we rephrase it this way, then it becomes clearer that risk is the loss or the gain  (rather than the event).

This is a conceptual shift from the previous definition used in 4360:2004 in which risk is the event and its likelihood ("the chance of something happening")

Let's apply these new definitions to an example risk. Suppose we have to deliver a product by March 30, 2010, and if we fail to deliver it, our client loses $30,000 per day.

Then by 4360:2004's definition that the risk is the event that has an impact on objectives, we have the risk as "risk that product will be delivered late."  And the impact / consequence will be that the client stands to lose $30,000 per day.

And by 31000:2009's definition where the risk is the effect of the event, we have the risk as "risk of losing $30,000 per day" and the consequence is whatever the impact of that impact.  What about the event of failing to deliver on time?  Then that is a cause of the risk.

Both standards recommend qualification (or if applicable, quantification) of the likelihood of the event, so we should apply some description of likelihood to the risk. Let's say the likelihood of meeting the deadline has been assessed at 90%. So our risks are:

• Risk as per 4360: 10% chance that the product will be delivered late.
• Risk as per 31000: 10% chance that the client will lose $30,000 per day.

The definition of risk as per 31000 is consistent with their note: "Note 4: Risk is often expressed in terms of a combination of the consequences of an event (including changes in circumstances) and the associated likelihood (2.21) of occurrence."

I think I have finally nailed to my satisfaction what the drafters of ISO 31000 mean when
they say risk is "the effect of uncertainty on objectives". I still do not like their definition, and I think it is muddled (primarily because of the desire to incorporate positive risks), but I have a workable meaning now, which I can use for further work.

Example of a Decision Tree

A simple example of using a decision tree to help us with decision-making.

A couple renting an apartment and is wondering whether they should sign a 1-year contract on the rent.  If they sign a contract, their rent is guaranteed not to increase during the 1-year period. If they don’t sign a contract, their rent will increase by about $20 after 6 months.

This seems like a simple decision.  But there is a drawback to signing the contract. If the couple decides to terminate the contract before the end of 1 year, they are liable to pay up to 25 weeks worth of rent to the landlord, unless the landlord is able to get someone else to rent the place earlier. 

The couple intends to buy their own home if the right opportunity comes, so there is a chance that they would need to terminate any contract they sign.

Supposing the initial rent is $900 per month, what is the couple’s best option?

Let us choose the simplest situation first.  Let’s assume there is zero chance that the couple will terminate the contract.  So the decision tree looks like this:

The tree says that the option to sign a lease contract will result in a total 1-year rent of $10,800 ($900 * 12 months), while not signing a lease contract will result in a total 1-year rent of $11,800 ($900 * 6 months + $900 * 1.2 * 6 months).

But what happens if the couple finds their dream house and moves out of the house after 8 months?

The Essence of Risk Management

All of man’s activities is fraught with uncertainty and risk.  When he undertakes something, he faces uncertainty and risk and loss.  Even when he does not undertake anything new, but simply goes on with life as normal, he still faces uncertainty and risk and loss.

Therein lies the essence of risk management, to which man runs to, to seek an answer to his question: in the face of this uncertainty, what should we do?

Operations Risk

Every company faces risks as it goes about its day-to-day operations.  A bank branch could find itself in the midst of a robbery.  A fastfood restaurant could suddenly have a cook badly burned by an overturned pot filled with boiling water.  A shipping company may have one of its ships boarded by pirates.  A veterinary clinic may have one of its staff or customers bitten by a dog. A data centre may find the building it is located in collapsing due to an earthquake. These risks are called ‘Operations Risk’, or alternatively ‘Operational Risk’. 

The types of operations risk a company faces depends heavily on its line of business, although the nature of risk is that it is often unexpected: the bank could suddenly discover that the pirates who boarded the ship in the above example are actually the bank’s customers.  The shipping company may find its cook burned badly while preparing food.

Operations risk is different from the other types of risks that companies face.  It is not credit risk, which is the risk related to debtors not paying the company.  It is not strategic risk.  It is not market risk.  It is not reputation risk.  Nevertheless, risks arising from operations can cascade into these types of risks.  The revelation that a pirate has been hoarding its loot in your bank can rapidly discredit the bank (reputation risk). 

Concatenation of Risk

Currently reading J. Davidson Frame’s “Managing Risk in Organizations”.  Great example of a seemingly insignificant event cascading into a major headache.  The printing press experiences a fire and will not be able to deliver brochures expected to be that were supposed to come today.  These brochures are needed for a client’s conference in two weeks time. All the arranged plans to sort, label, and send them out have to be replanned.