Risk

War and football are risky: people get hurt and underdogs sometimes win. Leaving home is risky. Staying home is risky. Getting married is risky. Running a business is risky. Hiring new workers is risky; not hiring new workers is risky.

People react to risk along a continuum from risk phobic to risk seeking. If the chances were equal that demanding more money during salary negotiation would succeed or result in losing the job, the risk accepting would take the chance. The risk-averse individual would not, and the risk-neutral might flip a coin to decide what to do. The risk seeker might start a business rather than do anything so mundane as working for someone else, while the risk-phobic person would accept the first offer made by the prospective employer. An individual is likely to be more risk-averse with unemployment insurance running out than he would be if he had a perfectly satisfactory job. That is, tolerance for risk varies with both personality and circumstance. By definition, a risk-neutral individual is indifferent between two choices with an equal payoff. In the same circumstance, the risk-accepting person would take the chance, while the risk-averse person would not. The risk seeker seems compelled to take dangerous and unnecessary chances, while the risk-phobic is virtually petrified of even a sure thing going wrong.

People ignore seat belts or fear miniscule amounts of carcinogens in foods more than driving drunk, medical error, obesity, and smoking.

· They assume things will go as planned and have no plan if they do not

· They decide before the facts are in and have trouble changing their mind

· They don’t realize how several small failures can produce disaster

· They fear rocking the boat

· They find it hard to compare different types of data

· They find it hard to see the big picture in complex situations

· They put too much faith in backup systems

· They rely more on anecdotes than systematic information

· They underestimate big risks and overestimate small ones

Furthermore, in some circumstances, the possibility of deception affects risk. In football, teams attempt to disguise the planned play or try surprise plays such as fake punts. Armies, navies, and air forces practice security and deception to achieve surprise.² The best deceptions integrate five basic concepts, illustrated by D-Day in World War II:

· Exploit the opponent’s assumptions. Normandy and Pas de Calais were the only possible invasion points and both sides knew it. The Allies chose the former because the Germans expected the latter, then focused the deception plan on what the Germans expected.

· Know what you want the opponent to do. The objective was to keep the main German force at Pas de Calais at least until the beachheads were strong enough to resist counterattack.

· Use several different types of information to drop mere hints that add up to the desired conclusion. Preparatory bombing patterns, fake bases, and a host of other devices pointed toward Pas de Calais.

· Allow the opponent enough time to discover, analyze, and act on the information. The D-Day deception began over a year before the invasion.

· Continue the deception as long as possible.

Deception has risks. Seen through, it can lead to disaster, as probably would have been the case had the Germans realized that all the clues suggesting the Allies planned to invade Europe at Pas de Calais were part of an Allied deception, leaving Normandy as the only viable invasion point.

Finally, risk is only one factor in making decisions. For example, to lower production costs, gain efficiencies from centralized production, better secure secret manufacturing methods, and improve control of its supply chain—worthwhile goals all—Caterpillar concentrated manufacture of high-pressure couplings, needed for virtually every machine it makes, in a single plant in Oxford, Mississippi. In 2008, a tornado destroyed the plant, disrupting production in all of its plants and costing the company millions.

We began to understand risk only after Fibonacci introduced the zero and the Hindu-Arabic numbering system to the Europe in 1202.³ Soon after, Cardano calculated the odds for each possible outcome of the roll of two dice, something nobody had been able to do although people had played dice for centuries. John Gaunt then calculated average life expectancy and Halley (more famous for his less useful discovery of a comet) developed the first mortality tables. This opened the way to offering life insurance

From these beginnings, mathematicians developed methods for dealing with risks of all sorts. Thus, we have bond ratings, calls, derivatives, futures, hedging, portfolio diversification, puts, and selling short against the box among the tools to manage financial risk. Federal deposit insurance, unemployment insurance, welfare, social security, pensions, and life insurance further reduce financial risk and dampen economic cycles. Health insurance, Medicare, and extended care insurance reduce risks due to illness. We now can calculate the likelihood and cost of almost any imaginable risk.

Risk may be manageable but cannot be eliminated. Attempts to do so, by legislation, regulation, or litigation, inevitably result in unintended and unpleasant consequences, as we saw in the 2008 financial crisis. Successful risk managers (a profession in its own right) must understand both the emotional and rational dimensions inherent in any conflict. In markets with a free, competitive price system and well-defined property rights, the optimal result comes from everyone doing what is best for oneself. Some critics assert that this works only in contrived laboratory experiments in which consumers have perfect information and negligible transaction costs. Direct real-world results reported by Kenneth Arrow and Gerard Debreu strongly suggest the opposite (Chapter 11). Theoreticians must continue to improve ways of integrating the way we think about risk with the causes, processes, and outcomes of conflict.