The Failure of Risk Management: Why It's Broken and How to Fix It

A practical guide to adopting an accurate risk analysis methodology

The Failure of Risk Management provides effective solutionstosignificantfaults in current risk analysis methods. Conventional approaches to managing risk lack accurate quantitative analysis methods, yielding strategies that can actually make things worse. Many widely used methods have no systems to measure performance, resulting in inaccurate selection and ineffective application of risk management strategies. These fundamental flaws propagate unrealistic perceptions of risk in business, government, and the general public. This book provides expert examination of essential areas of risk management, including risk assessment and evaluation methods, risk mitigation strategies, common errors in quantitative models, and more. Guidance on topics such as probability modelling and empirical inputs emphasizes the efficacy of appropriate risk methodology in practical applications. 

Recognized as a leader in the field of risk management, author Douglas W. Hubbard combines science-based analysis with real-world examples to present a detailed investigation of risk management practices. This revised and updated second edition includes updated data sets and checklists, expanded coverage of innovative statistical methods, and new cases of current risk management issues such as data breaches and natural disasters.

• Identify deficiencies in your current risk management strategy and take appropriate corrective measures
• Adopt a calibrated approach to risk analysis using up-to-date statistical tools
• Employ accurate quantitative risk analysis and modelling methods
• Keep pace with new developments in the rapidly expanding risk analysis industry

Risk analysis is a vital component of government policy, public safety, banking and finance, and many other public and private institutions. The Failure of Risk Management: Why It's Broken and How to Fix It is a valuable resource for business leaders, policy makers, managers, consultants, and practitioners across industries. 

DOUGLAS W. HUBBARD is the inventor of Applied Information Economics (AIE). His methodology has earned him critical praise from Gartner and Forrester Research. He is also the author of How to Measure Anything: Finding the Value of Intangibles in Business and How to Measure Anything in Cybersecurity Risk. His articles appear in Nature, The American Statistician, The IBM Journal of R&D, InformationWeek and many more. He has over 30 years of experience in management consulting focusing on the application of quantitative methods in decision making

About the Author xi

Preface xiii

Acknowledgments xvii

Part One An Introduction To The Crisis 1

Chapter 1 Healthy Skepticism for Risk Management 3

A “Common Mode Failure” 5

Key Definitions: Risk Management and Some Related Terms 8

What Failure Means 14

Scope and Objectives of This Book 17

Chapter 2 A Summary of the Current State of Risk Management 21

A Short and Entirely-Too-Superficial History of Risk 21

Current State of Risk Management in the Organization 25

Current Risks and How They are Assessed 26

Chapter 3 How Do We Know What Works? 35

Anecdote: The Risk of Outsourcing Drug Manufacturing 36

Why It’s Hard to Know What Works 40

An Assessment of Self-Assessments 44

Potential Objective Evaluations of Risk Management 48

What We May Find 57

Chapter 4 Getting Started: A Simple Straw Man Quantitative Model 61

A Simple One-for-One Substitution 63

The Expert as the Instrument 64

A Quick Overview of “Uncertainty Math” 67

Establishing Risk Tolerance 72

Supporting the Decision: A Return on Mitigation 73

Making the Straw Man Better 75

Part Two Why It’s Broken 79

Chapter 5 The “Four Horsemen” of Risk Management: Some (Mostly) Sincere Attempts to Prevent an Apocalypse 81

Actuaries 83

War Quants: How World War II Changed Risk Analysis Forever 86

Economists 90

Management Consulting: How a Power Tie and a Good Pitch Changed Risk Management 96

Comparing the Horsemen 103

Major Risk Management Problems to Be Addressed 105

Chapter 6 An Ivory Tower of Babel: Fixing the Confusion about Risk 109

The Frank Knight Definition 111

Knight’s Influence in Finance and Project Management 114

A Construction Engineering Definition 118

Risk as Expected Loss 119

Defining Risk Tolerance 121

Defining Probability 128

Enriching the Lexicon 131

Chapter 7 The Limits of Expert Knowledge: Why We Don’t Know What We Think We Know about Uncertainty 135

The Right Stuff: How a Group of Psychologists Might Save Risk Analysis 137

Mental Math: Why We Shouldn’t Trust the Numbers in Our Heads 139

“Catastrophic” Overconfidence 142

The Mind of “Aces”: Possible Causes and Consequences of Overconfidence 150

Inconsistencies and Artifacts: What Shouldn’t Matter Does 155

Answers to Calibration Tests 160

Chapter 8 Worse Than Useless: The Most Popular Risk Assessment Method and Why It Doesn’t Work 163

A Few Examples of Scores and Matrices 164

Does That Come in “Medium”?: Why Ambiguity Does Not Offset Uncertainty 170

Unintended Effects of Scales: What You Don’t Know Can Hurt You 173

Different but Similar-Sounding Methods and Similar but Different-Sounding Methods 183

Chapter 9 Bears, Swans and Other Obstacles to Improved Risk Management 193

Algorithm Aversion and a Key Fallacy 194

Algorithms versus Experts: Generalizing the Findings 198

A Note about Black Swans 203

Major Mathematical Misconceptions 209

We’re Special: The Belief That Risk Analysis Might Work, but Not Here 217

Chapter 10 Where Even the Quants Go Wrong: Common and Fundamental Errors in Quantitative Models 223

A Survey of Analysts Using Monte Carlos 224

The Risk Paradox 228

Financial Models and the Shape of Disaster: Why Normal Isn’t So Normal 236

Following Your Inner Cow: The Problem with Correlations 243

The Measurement Inversion 248

Is Monte Carlo Too Complicated? 250

Part Three How to Fix It 255

Chapter 11 Starting with What Works 257

Speak the Language 259

Getting Your Probabilities Calibrated 266

Using Data for Initial Benchmarks 272

Checking the Substitution 280

Simple Risk Management 285

Chapter 12 Improving the Model 293

Empirical Inputs 294

Adding Detail to the Model 305

Advanced Methods for Improving Expert’s Subjective Estimates 312

Other Monte Carlo Tools 315

Self-Examinations for Modelers 317

Chapter 13 The Risk Community: Intra- and Extra-organizational Issues of Risk Management 323

Getting Organized 324

Managing the Model 327

Incentives for a Calibrated Culture 331

Extraorganizational Issues: Solutions beyond Your Office Building 337

Practical Observations from Trustmark 339

Final Thoughts on Quantitative Models and Better Decisions 341

Additional Calibration Tests and Answers 345

Index 357

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