Responding to risks

Responding to risks - the actions you can take once you've identified a risk and understood its probability and impact.

There are usually risks that cannot be avoided in business, no matter what alternative we choose.  Our decisions therefore focus on how we will respond to them, rather than trying to avoid them.   Responses to risk will vary from business to business and from risk to risk, but they tend to fall into one of these categories:

• eliminating
• tolerating
• minimising
• diversifying
• concentrating
• hedging
• transferring
• insuring

Deciding which of these responses is appropriate in any given situation requires careful analysis of the risk in terms of probability, impact and potential outcomes (expected values).

Getting it right

Whatever approach you choose to the risks you face, there are central themes to risk management that have to be in place for it to be successful.

Effective decision making and risk management are based on understanding, information and consistency.  It is vital that everyone involved is working from a shared idea of the significance of the risks facing the business, the probability of them occurring and the actions that they need to take in order to minimise downsides (or maximise upsides).

Here are some questions to ask in key areas to assess your risk management capabilities:

understanding operational risk:

• are the risks that can arise in key business process understood?
• are the implications of choosing or creating particular new processes understood?
• are the impacts of operational risk understood, in terms of their immediate impact and also any potential impacts at higher levels?

understanding strategic risk:

• are decision makers aware of the strategic risks facing the business?
• are the implications of 'doing nothing' or continuing along the present course understood?
• has 'business as usual' been examined in the same way as a 'risky' new direction would be?
• have the risks implied simply by entering or remaining in a particular market been examined?

understanding probability:

• have probabilities been quantified in a consistent way, that allows for comparison?
• what evidence is there to support estimates of probability?
• where there is uncertainty, has this been understood and acknowledged by decision makers?
• is there shared understanding of the subjectivity involved in probability calculations?

understanding impact:

• have impacts been quantified wherever possible, to allow for comparison?
• is it clear where risks might impact on more than one area of the business?
• is there the potential for risks to have interdependencies, making the occurrence of two or more risks together more significant?
• are the different levels of impact understood (operations, strategy, financial, cultural)?

information:

• documenting:  how will risks, responses and results be documented?  what proceducres will be used for recording the actions taken to manage risks and their results?
• sharing:  how will information on risks and the success (or otherwise) of particular response be disseminated throughout the business, to avoid duplication of effort?
• communicating:  who owns key information? who does it need to reach in order to support decisions on risk? what are the best media, formats and techniques for communicating?

clear roles and responsibilities:

• whose responsibility is each risk? who 'owns' it by default?
• who has enough authority and/or information to take a decision on how risks will be managed?
• who will take action to manage the risk?  who will become its new 'owner'?

reporting and monitoring:

• who needs to know what, and when?
• what is the best medium or channel to provide information on risks, such that those who need to take decisions have the information they need in a format they will find conducive?

consistency of approach:

• if similar risks occur in different parts of the business, is the response the same?
• could risks easily be aggregated across the business if this kind of concentration brought benefits?

consistency of analysis:

• where possible, are risks assessed using standard, objective criteria, or at least those that are agreed by all within the business?

consistency of tools and techniques:

• where decision-making tools are used, are they used in a consistent way across departments and teams?
• is there a genuine shared perspective on risks that affect different groups?

consistency of terminology:

• are risks described in terms that allow meaningful comparison and evaluation across the business?
• are common terms used with the same sense throught the business?
• are there any aspects that need to be quantified, or made less subjective, to allow for more focused discussion between those involved?

Understanding Risk and Decision Making

Key ideas:

Probability is the likelihood of an outcome.  Probabilities are expressed numerically, but are often subjective.

Impact is the effect that a particular outcome will have.

Decision trees help us get a grip on our alternatives.

The concept of expected value helps us compare alternatives based on probability and impact.

Risk profies take us beyond expected value to consider unacceptable or fatal downsides.

Getting more information to reduce subjectivity in decision making takes time and costs money


Ref:
Risk:  How to make decisions in an uncertain world
Editor:  Zeger Degraeve

It's important to remember that people are the real decision makers.

Tools and techniques for decision making:  Means, not ends

However you go about making decisions, it's important to remember that people are the real decision makers.  Tools and techniques such as decision tress help to generate insight into a problem, stimulate communication and build a shared understanding of it, but they cannot take the decision for you.  In the last analysis, business decisions are about people - in every sense. 

Our favoured courses of action often flow more from our own values than from what is objectively 'right' in a situation.  Our estimates of probability are similarly subjective.  And in assessing impact, we are likely to be highly subjective too, perhaps concentrating on those areas of downside or upside that affect us most directly. 
The danger of using models such as those discussed in the previous postings is that they can give the illusion of objectivity.  Writing things down and analysing them is important, but the main benefit of doing so is to bring clarity to a decision, rather than precision.

We have to remember that tools and techniques are only as good as the information we put into them.  They are dependent on the extent and accuracy of information available at the time the decision is taken.  No matter how we present or analyse the information we have, we cannot add to it or make it any more reliable than it already is.  All we can do is aim for a shared sense of what we know and what we don't know, to build an informed consensus for particular courses of action.

Only people can build a bridge from the information that is available to a decision that can be taken forward.


Tools for risk assessement: and decisions making:
Probability
Subjective probabilities
Impact: hard and soft
Decision trees
Expected value
Fatal downsides
Life decisions
A business decision
Break-even analysis
Risk profiles
Probability/Impact matrix

The Information Trade-Off

Obtaining more information can help improve the quality of decisions by providing more detail about impacts and reducing subjectivity over probabilities.  It also helps to build up awareness of other alternatives that could be taken.  In general, it is a given that seeking more information will be beneficial to decision makers, having the general effect of reducing the level of uncertainty involved in a decision, and making it more likely that the outcomes of particular decisions will provide opportunities for learning.

However, there is a trade-off to be made.  Decisions usually have to be taken within a particular timeframe, and getting more information takes time.  It can also cost moneuy.

Both of these have implications for the level of extra effort that goes into facilitating more informed decision making.

The decision makers can reduce subjectivity by researching what is going on in various areas.  As they learn more and more, the probability that they are assessing becomes less and less subjective.  In the end (in theory at least), they can arrive at an objective probability.  However, there are some important issues facing them:

• getting information takes time:  the report must be submitted at a given deadline, even if they havent't pinned down the probability of the event occuring.
• gettting information costs money:  doing research will use up the resources of the business; you have to decide how much investment in information to support decision making is appropriate; this means assessing how sure you can be of the information you do have, and how much more certainty can be achieved for a reasonable cost
• situations change over time:  as you collect information to help you make a decision, the context or nature of the decision may be changing; there may be a limit to the accuracy you can achieve.

Inevitably, decisions have to be made with limited information.  Before you make a decision, you have to decide whether the information at your disposal is sufficient to make the decision, or whether you are going to make an investment (in terms of time or money, or both) in getting more information - and how this might affect the nature of the decision itself.  (You also need to guard against certain psychological traps.)

Management actions feed into decisions and affect their outcomes, whether this is in the form of considering decisions for longer, obtaining more information or just bringing different personal perspectives and experience to bear on the decision.  There will always be uncertainty involved, but by putting time and effort into decision making, its negative effects can be minimised.  In many decision situations, there is a 'third way' - the choice not to follow one of the branches on the tree, but to invest more effort in refining the picture of the decision before it is taken.

This poses interesting questions:

• how much is your time worth?
• what potential downside of this decision would you be prepared to accept if you could spend the time thinking about another issue instead?
• what potential upside do you regard as being a good 'purchase' to make with your time?

Up to this stage, you have acquired the knowledge you need to assess whether simple games of chance are worth playing.  Business decisions are much more complex and subltle than this, and you will never reach a point where you 'know everything', as in the dice game.  The issue is how much time to put into making a decision, and whether to put additional resource in obtaining more information before making the decision. 

In the end, this is likely to be a judgement call.  While time can be quantified and given a nominal cost,k the benefit to be obtained from it is likely to be very difficult to quantify.  In fact, until you actually invest the time, you cannot know how beneficial the information you gain will be.  We have to deal with this contradiction every time we take a business decision.

Probability/impact matrix to compare importance and urgency of one risk relative to another.

Probability/impact matrix


Having gauged the probability and impact of a number of risks, you can use the probability/impact matrix to compare them by assessing their importance or urgency relative to one another.  This diagram shows some risks that many of us face in our working lives, by way of illustration.  http://spreadsheets.google.com/pub?key=t5huetUWENmggchcXyeL9MQ&output=html

As with the other tools in this section, the matrix functions as a starting point for decision making.  It's a good way to display or share information on a number of risks facing the business, perhaps to form the basis for a meeting.  It might be possible to compare the different risks to each other, perhaps in order to highlight situations where disproportionate effort is being put into managing a particualr risk that is unlikely to occur, while another risk that is far more likely is being neglected.  Where risks are only expressed in verbal terms, there is a tendency to concentrate on those that sound worst rather than those that really do present the most likely or severe downside to the business.  The matrix can be used to help prioritise actions or focus efforts where they will have the most beneficial effect. 

As with the other tools, it is important to remember that the probability/impact matrix is only useful in proportion to the accuracy of your own assessments of probability and impact.  You only get out of it what you put in.


Tools for risk assessement:
Probability
Subjective probabilities
Impact: hard and soft
Decision trees
Expected value
Fatal downsides
Life decisions
A business decision
Break-even analysis
Risk profiles
Probability/Impact matrix

A picture of complex risks and their profiles is more useful than knowing expected value is positive or not

Risk profile

A risk profile is a graph showing value - usually expressed in financial terms - and probability.  Looking at the profile of a risk can give a more sophisticated view of it than expected value alone. 

http://spreadsheets.google.com/pub?key=tHk2EpsXiBSmmV6BILRm7IA&output=html


Let's consider a third version of the dice game - version C.  As before, throwing different numbers brings different outcomes.  But in this version, there is the possibility of a severe downside.  Thowing 5 or 6 wins $10; throwing 2, 3, or 4 wins $5; throwing 1 incurs a $10 penalty.

The different outcomes and probabilities are shown in the table above, along with the calculation of expected value for this game.  As before, expected value is calculated by adding together the products of impact and probability for all possible outcomes. 

At first glance, this game looks like the best so far - its expected value is far higher than that of either version A or version B.   ( http://spreadsheets.google.com/pub?key=te9MzyHoIN6EyuoHmfDxMaw&output=html)

But what about the potential downside?  With $5 in our pocket to play with, we could easily incur a debt that we can't pay, and have to declare ourselves bankrupt.  With $20 to play with, we would be a bit safer (the wealth effect). 

The key to this decision is the profile of the risk.  (see the diagram of the risk profile for dice game version C above).    Each vertical black coloured bar represents a possible outcome.  Its position denotes its impact (negative to the left, positive to the right); its height denotes its probability.  The positive side of the graph looks promising, with high probabilities for positive outcomes.  But over on the left, we see the possibility of a serious negative outcome - a potentially fatal downside.  The risk may have an unacceptable profile for us, despite its positive expected value.

More complex risk profiles bring in more and more possible outcomes and probabilities.  They build up a picture of complex risks and their profiles that is more useful than the simple question of whether the expected value is positive or not.

Histograms plot value against probability density, to give a continuous version of the risk's profile.  They are created through advanced risk anlalysis involving techniques such as Monte Carlo simulations, where a large number of probabilities is used to create the risk profile.

Making Life Decisions: appraising cost, risk and expected value, with limited information about the future

The dice games are simple parallels with the type of decision we take every day in our lives.  Investments offer the most direct comparison.  With a limited sum to invest, you have to evaluate the probability of making a profit, the expected value and the risk involved for each investment alternative.  And, as with the dice, you hve the alternative not to play, which is 100% safe, but will not make you any money.

We make other kinds of decisions too, where the investment is not always financial:

• selecting a savings account (which will make you richest in the long term?)
• buying a house ( will prices fall or rise?)
• deciding which people to socialise with (who will turn out to be better company?)
• renting a film to watch (which will you enjoy the most?)

However vaguely or subconsciously, we are appraising cost, risk and expected value, with limited information about the future, all the time - even if the only cost is our leisure time, the only expected value a fleeting enjoyment, and the only potential loss a mild feeling of irritation.

Fatal downside and Wealth effect

Although the overall expected value of dice game version A is positive, there is one situation in which you should not play it - when the potential downside would be fatal or disastrous for you.

http://spreadsheets.google.com/pub?key=te9MzyHoIN6EyuoHmfDxMaw&output=html

If you had just $1 in your pocket, played the game once, and failed to throw a six, you would be bankrupt.  The positive expected value of the game would be no help to you, since you would be unable to play any more - a fatal downside would have occurred.  In other  words, it is not enough just o look at the expected value of a decision.  The probability of a fatal or disastrous worst-case scenario has to be considered too. 

The presence of a fatal downside might temper your enthusiasm for a decision with a positive expected value, perhaps encouraging some kind of trade-off between expected value and the potential for exposure to a fatal downside.  You might be better finding another dice game perhaps a version that cost 10 cents to play, with a prize of 50 cents.  This would have the advantage of allowing you to stop playing before you went bankrupt, should you hit a bad losing streak.

By doing this, you would be spreading the risk around rather than going for an 'all or nothing' risk- trading off a better risk profile for a lower expected value.  (This approach to managing risk is known as 'diversifying'.)

In business terms, this translates into considering whether the downside of a risk, if it occurred, would result in bankruptcy or any situation from which the business could not recover.  The possibility of this, however remote, would have to be taken into account when contemplating a risk with positive expected value.

The fact that fatal downsides in investment loom much larger for smaller companies results in the 'wealth effect' - the relative ease with which larger companies can accumulate wealth.  They can take investment risk with positive expected values but serious potential downsides, because the fear of bankruptcy is more distant for them.  And the more positive-value decisions they take, the more money they accumulate and the more risks they can tolerate in their investments.  They can also afford to take more risks when considering and trying out new directions.  Individuals can also exhibit the wealth effect:  people with more cash saved up can afford to take bigger risks with their careers, perhaps allowing them to achieve greater successes.

It is the nature of know risk probabilities that the longer the run of risk taking, the closer one gets to the delivery of expected values.  This is how gambling becomes a science - with deep enough pockets (the wealth effect) and enough time, pay-offs come to reflect odds.  It is in the short run that 'luck' brings fortune or disaster.

Decision making: Risk, Probability, Impact, Subjectivity, Decision trees and Expected Value

You are invited to play dice games version A and version B.  In this game, you bet $1 on the throw of a dice.  Throwing a six wins a prize; throwing any other number means you lose your $1.

In version A of this game, a bet costs $1, but you can win $10.  Faced with this game, you have two alternatives - to play or not to play.  Once playing, there is nothing you can do to affect the outcome - so your decision on whether to play has to be made on the basis of the probabilities and impacts involved.  They are depicted on the decision tree here to help your decision.

http://spreadsheets.google.com/pub?key=te9MzyHoIN6EyuoHmfDxMaw&output=html

Because the situation is simple, the probabilities of the various possible outcomes can be objectively known.  There is no subjectivity over the probabilities.  The impacts, too, are fixed and clearly set out by the rules of the games (the prizes and the cost of playing).  If a choice is made to play, the probability of winning is 1 in 6 (0.166 or 16.6%) and the probability of losing 5 in 6 (0.834 or 83.4%).  If a choice is made not to play, risk is avoided (there is a single outcome that is certain) but there is also no potential benefit. 

In version B of the dice game, the stake and odds remain the same, but you can only win $5.  The alternative not to play remains.  In each case, we have to decide whether to play or not.  There is the alternative to walk away, but this offers no benefit.  Is it better to play or not to play?  Version A seems better than version B, but how much better?  Is B worth playing as well, despite the lower prize?  How can we make a decision about where to make an investment?  Most people can offer answers to these questions based on an intuitive, subjective grasp of probability and impact.  We make decisions all the time on this basis.  But for business decisions, we need to move beyond subjectivity whenever we can.  We need to quantify things wherever possible.


The concept of expected value (EV)

To compare different alternatives against each other in a quantitative way in order to determine whether a risk is worth taking, we can use the concept of expected value (EV).  The expected value of a risk is obtained by multiplying probability by impact for each possible outcome, and adding all the results together.  If a particular impact is negative, the value for that outcome is also negative. 

The table below shows the expected value calculation for playing version A of the dice game.  The expected value is 0.66.  Because this is a positive value, it indicates that the game is worth playing.

http://spreadsheets.google.com/pub?key=te9MzyHoIN6EyuoHmfDxMaw&output=html

In version B, because of the reduced prize (a variation in impact), the picture is different.  This is shown in the table also.  Because of the reduced prize, the expected value of version B is negative.  If you play it repeatedly, you will steadily lose money over time.

In this case, the alternative not to play, although it brings no benefit, has a higher expected value (zero) than playing (-0.17).  You are better off keeping your $1.

Expected value helps us ascertain whether a particular alternative is worth taking, based on our knowledge of probabilities and impacts.  But, unless the outcome of a decision is certain, expected value can only ever be used as a guide.

In version A, for example, the expected value of not playing is zero, and this is certain.  But if you decide to play, the only possible outcomes are winning $10 or losing your $1 - in other words, values of either +9 or -1.  An impact of +0.66 (the expected value) is impossible. 
And, while a positive expected value of 0.66 makes the game nominally 'worth playing', the outcome of playing is not certain.  You might still lose.

Conversely, the negative expected value of version B, while it indicates you should not play, doesn't necessarily mean you won't win if you do.  The possible outcomes are value of +$4 or - $1.  You might play once and win.  You might even play three times in a row and win all three times, although the probabhility of this is 0.0046 (or less than 1%).  Despite the negative expected value, a positive outcome remains possible.

The actual probability of realising the expected value as a result of a single decision is zero.  However, if you played version A 100 times, you would find the average value across those many decisions tending towards 0.66 - you would have around $166 in your pocket.  This would prove the accuracy of your initial calculation of expected value.

Calcuating or estimating expected value wrongly - or not wanting to calculate it at all - has serious consequences for decision making.  Consider the National Lottery.  Although the prize (potential upside) is enormous, the tiny probability of winning gives the game a negative expected value.  But the lure of the prize outweighs the rational considerations of probability, making people mentally distort probabilities (if they consciously think in those terms at all) and decide to take an illogical risk.  This is the essence of the appeal of gambling, and points the way towards the psychology of risk.

So, despite the name, we can never expect the expected value.  Some may ask, in that case, why use the concept at all?  The answer is to help in making decisions, rather than in predicting the future.  As we've seen, there are no facts about the future, only probabilities.  In this case, probabilities are known but a reliable prediction of the outcome remains impossible - the dice will decide!

We have already seen how, in most business decisions, the picture is clouded by subjectivity.  Not only is it impossible to predict the future, there will also be uncertainty over impacts and probabilities.

Expected value is calculated from probability and impact information or estimates.  Whatever subjectivity or imprecision is inherent in our probability and impact figures will feed through into expected values.  There are only as good as the information from which they are calculated.  Therefore, just as with probabilities, it is important to remember, and explain to others, when subjectivity is a factor.

When Was the Last Time You De-learned?

When Was the Last Time You De-learned?

05:44 PM Thursday November 19, 2009


By Vineet Nayar

Students all over the world are hard at work in school at this time of year. There's a buzz on every campus as young women and men learn the rules of life, challenge them, and try to develop their own ideas, values, and principles.

For people in business, especially those who graduated a long time ago, it's time they went back to school in order to, for want of a better phrase, de-learn and un-graduate. That's the only way we will learn to challenge all that we have so far accepted as time-tested truths.

Although it isn't easy, executives should shed their fear of the unknown and display childlike enthusiasm for radical ideas. They need to ask tough questions even if there are no answers to them — yet. In business, unlearning entails changing the manner in which markets are defined and the way companies are run. It also involves rethinking perceptions about competition and collaboration.

As it is, executives tend to gravitate toward their zones of comfort as they grow older — and then wonder why the magic has disappeared from work.

Revisit your youth and ask yourself: Was I looking for simple and practical solutions then? Or did I ask tough questions that challenged people's assumptions, beliefs, and values? History suggests that people who challenge the status quo — like Isaac Newton and Albert Einstein — often come up with great inventions.

Most important, executives have to change their approach to business and society. They usually believe they have all the answers and that their ways of doing things are the best. However, leaders must accept the fact that they don't have all the answers and re-program themselves for a world of infinite possibilities.

Great leaders are often lonely thinkers who ask uncomfortable questions, walk tough paths, and challenge popular perceptions. Only in retrospect are Mahatma Gandhi and Nelson Mandela — who faced criticism for most of their lives — regarded as great leaders who fought for the right causes. They loom large even now not because they had the answers, but because they dared to question. And by doing so, they achieved results whose value can't be questioned.

When was the last time you dared question the status quo?

Top 10 paradoxes of Warren Buffett

Top 10 paradoxes of Warren Buffett


Mr Buffett still lives within a mile or two of where he was born

Warren Buffett is different from the rest of the super-rich in many ways, large and small.

He makes investment sound simple and has a talent for explaining it to the public.

But, as his biographer, Alice Schroeder says in BBC Two's 'The World's Greatest Money Maker: Evan Davis meets Warren Buffett', his method is "simple, but it's not easy".

There's more to the billionaire investor than meets the eye. However simple he'd like to make earning $40bn (£25bn) look, the Buffett story isn't entirely straightforward.

Here are 10 paradoxes that could offer an insight:

1. Mr Buffett has managed to make more money than other investors by being less ambitious. While Wall Street whizz kids set their sights on high returns, using leverage, Mr Buffett's steady annual compounding of increases, avoiding debt, has worked better.

2. Mr Buffett uses a conservative approach to picking investments - "don't lose money" is one of his favourite rules. But much of his cash comes from insurance companies that specialise in very high risk events - catastrophe insurance.

3. Mr Buffett is famous for his analytical study of the figures and unemotional response to the market. And yet among his greatest assets are his personality and reputation - both unquantifiable - and the trust they engender in potential business partners.

4. Extremely cautious with money, Mr Buffett is nevertheless happy to make "big bets" when he likes a company or a share. Unlike most investors, he believes that, for professionals at least, diversifying one's investments only means including among them, second rate choices.

5. He has come a long way in his life, but still lives within a mile or two of where he was born.

6. Mr Buffett has made more money than almost everyone, but appears to have no use for it personally - except for the single indulgence of his private jet, which he called "The Indefensible".

7. The most acquisitive man in the world is also one of the most philanthropic. Three years ago, Mr Buffett announced he was giving away the bulk of his fortune to charity, including $31bn (£19bn) to the Bill and Melinda Gates Foundation.

8. Mr Buffett says he has "no strategy" for Berkshire Hathaway, and yet he puts endless time and energy into communicating his ideas about markets and how to run businesses.

9. The man who is famous for a simple, down-to-earth approach to money-making has been chairman of investment bank Salomon Brothers, has a huge investment in another, Goldman Sachs, and trades in currency and derivatives.

10. Mr Buffett is one of the world's best-known business people, and yet he has no use for marketing or promotion of his business, Berkshire Hathaway.

http://news.bbc.co.uk/2/hi/business/8322995.stm

Hands up if you want investment success like Warren Buffett

Warren Buffett's best investments
Hands up if you want investment success like Warren Buffett


When Warren Buffett bought Berkshire Hathaway in the 1960s, it was a working textile mill in New England.

He later closed down production when he decided it could never be a profitable business, but retained its name for his holding company.

Berkshire Hathaway is the corporate face of Warren Buffett - the firm in which he holds his investments and the businesses he has bought.

Its constituent companies and investments provide an insight into Mr Buffett's thinking.

So how has he chosen where to put his money?


BERKSHIRE HATHAWAY (1965)
Tracing its roots to a textile factory founded in 1839, by the 1950s Berkshire Hathaway had grown to fifteen plants employing 12,000 people. From 1962, Warren Buffett began to buy stocks in Berkshire Hathaway and by 1965 he had gained a majority share.

In 1985, struggling against competition from cheaper labour in overseas factories, the textile mill was closed. He is happy to admit that Berkshire Hathaway wasn't one of his best investment decisions.

But its share price tells a different story: Mr Buffett began buying shares in Berkshire Hathaway at $7.60 a share. Today, as his investment vehicle, each share is valued at around $100,000.


GEICO (1951-1996)
Mr Buffett's involvement in Geico stretches back to 1951, when his interest was sparked by his mentor, the business writer and investor, Benjamin Graham. Mr Graham was an investor in the insurance company, and the young Warren visited the company in Washington and began to buy a few shares.

Geico's success continued throughout the fifties and sixties, but by the mid-seventies the firm had run into trouble. In 1976 Mr Buffett stepped in, and through Berkshire Hathaway bought half a million shares in the company, only to see them quadruple in value in six months.

Twenty years later, the business cycle drooped again, offering Mr Buffett a chance to buy the company outright for $2.3 billion.

The investment, along with Berkshire Hathaway's other insurance companies, provides a cash float that allows Mr Buffett and his partner Charlie Munger to invest without having to borrow money.


DAIRY QUEEN (1998)
Buffett's love of ice cream and his eye for a business opportunity came together when Berkshire Hathaway bought Dairy Queen for $585 million.

With its familiar logo, glimpsed from highways and movies alike, the soft ice-cream company founded in 1940 has in excess of 5,700 outlets from Omaha to Oman.

Dairy Queen's fare now includes hamburgers and fries and soft drinks such asg Coca-Cola - a business in which Mr Buffett also has a large stake.

Since 2005, Dairy Queen has been expanding and lately announced its intention to open 500 more outlets in China over the next few years.

As Buffett put it in his annual shareholders' letter: "We have put our money where our mouth is."


COCA-COLA (1988)
Mr Buffett says he likes businesses he can understand.

Coca-Cola's business model isn't quite as simple as you might imagine - involving separate syrup production and bottling plants - but it's not rocket science.

First produced in 1895 as a syrup, the soft drinks company's advertising and its unique bottle gave Coke global recognition.

During the 1980s, Mr Buffett believed that Coca-Cola's share price did not reflect the company's steady returns, strong brand and opportunities for growth, so he started buying its shares.

Now with an 8.6% stake in the company, Berkshire Hathaway's commitment to this once-undervalued firm has paid off - and is now worth more than $10 billion.


GOLDMAN SACHS (2008)
Warren Buffett may be best known as the Oracle of Omaha, but he became Goldman Sachs' knight in shining armour during the financial crisis which hit Wall Street last year.

On 23rd September 2008, Berkshire Hathaway invested $5 billion in the company, matching a publicly raised investment.

Within hours, Goldman's shares had risen 6%.

Mr Buffett bolstered confidence in Goldman, and, at the same time, secured a favourable deal for Berkshire, with Goldman agreeing to pay Berkshire Hathaway a 10% annual dividend on the preferred stock, irrespective of Goldman Sach's common stock price.

http://news.bbc.co.uk/2/hi/business/8322999.stm

Warren Buffett's words of wisdom

Warren Buffett's words of wisdom
Warren Buffett, known to many as the Oracle of Omaha, is considered one of the world's greatest investors.

His financial success means that his words of wisdom, or Buffettisms, are treasured by many as elixirs of truth. Here's a selection:


Warren Buffett has built up a fortune estmated at $40bn


• Rule No.1: Never lose money.

Rule No.2: Never forget rule No.1

• Be fearful when others are greedy.

Be greedy when others are fearful

• It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price

• Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down

• Price is what you pay. Value is what you get

• It takes a lifetime to build a reputation and five minutes to ruin it

• Cash combined with courage in a crisis is priceless

• Never invest in a business you cannot understand

• Only buy something that you'd be perfectly happy to hold if the market shut down for ten years

• Someone is sitting in the shade today because someone planted a tree a long time ago

• Risk comes from not knowing what you're doing

• If you don't feel comfortable owning something for 10 years, then don't own it for 10 minutes

• If a business does well, the stock eventually follows

• I wouldn't mind going to jail if I had three cellmates who played bridge

• The fact that people will be full of greed, fear or folly is predictable. The sequence is not predictable

• Come to Omaha - the cradle of capitalism - in May and enjoy yourself.


The World's Greatest Money Maker

A falling market provides Buffett with the best opportunities

Sunday, 25 October 2009

Warren Buffett: Crisis, what crisis?

Warren Buffet explains his deal with Goldman Sachs
By Charles Miller
Money Programme


The world's greatest investor is weathering the financial crisis by practising what he preaches.

One of Warren Buffett's favourite sayings about the market is: "be greedy when others are fearful and fearful when others are greedy".

When the market was fearful last September, Mr Buffett was greedy, putting $5bn (£3bn) into the investment bank Goldman Sachs on exceptionally favourable terms.

He says he was only able to negotiate the deal because not many people had $5bn to hand at that particular moment.

But there is no doubt Mr Buffett's public show of confidence in the company was, in itself, a valuable asset to Goldman.

Mind-boggling returns

The deal already looks like a good one for Mr Buffett, with potential profits for him in the billions.

He has always enjoyed himself in a falling market, which, as he sees it, provides him with the best opportunities.

As if to prove his fabled status as the most successful investor ever, Mr Buffett prints his fund's spectacular growth record, all the way back to 1965, in the annual report of his company, Berkshire Hathaway.

It shows he has achieved an extraordinary 20.3% average annual growth in the company's value, which - he helpfully works out - comes to a mind-boggling 336,000% over the years - 84 times that of the standard US index fund, the S&P 500.

The numbers really are off the scale.

Using Decision trees to see how probability and impact relate to each other

We can use the simple example of a dice game.  In this game, you bet $1 on the throw of a dice.  Throwing a six wins a prize; throwing any other number means you lose your $1.

In version A of this game:

A bet costs $1, but you can win $10

Faced with this game, you have two alternatives - to play or not to play.

Once playing, there is nothing you can do to affect the outcome - so your decision on whether to play has to be made on the basis of the probabilities and impacts involved. 

Because the situation is simple, the probabilities of the various possible outcomes can be objectively known.  There is no subjectivity over the probabilities.  The impacts, too, are fixed and clearly set out by the rules of the game (the prizes and the cost of playing). 

If a choice is made to play, the probability of winning is 1 in 6 (0.166 or 16.66%) and the probability of losing 5 in 6 (0.834 or 83.4%). 

If a choice is made not to play, risk is avoided (there is a single outcome that is certain) but there is also no potential benefit.


Decision tree for dice game version A:

Decision:  Play dice game with chance of winning $10?  Yes or No

NO
Decision ---->  Risky Event  ---> Possible outcomes ---->   Probability ----->  Impact

No   ----->  Nil ------>  Avoid risk, keep money in pocket ----> 1.0 (certain) ----->  Neurtral: spend ntohing, win nothing


YES
Decision ----> Risky Event ---> Possible outcomes ----> Probability -----> Impact


Yes ----->  Stake $1 on throw of dice ----> Number 6  ----> 0.166 (1 in 6) ----> Gain Spend $1 Win $10
or
Yes -----> Stake $1 on throw of dice -----> Number 1, 2, 3, 4, or 5  -----> 0.834 (5 in 6) ---->  Loss Spend $1 Win nothing


http://spreadsheets.google.com/pub?key=te9MzyHoIN6EyuoHmfDxMaw&output=html

Subjectivity and Impacts

The problem of achieving objectivity applies just as much to assessing impacts as it does to gauging probabilities.  It can be difficult to establish a basis for comparison, praticularly in the area of 'soft' impacts.  As with probabilities, the key is to express impacts numerically.  The commonest way to do this is in financial terms.

'Hard' impacts often lend themselves to quantification and comparison, making it relatively easy to express them financially.  For example, an interruption to the operation of a production line resulting from a power cut or a fire could be translated into likely impact on revenues or profits.

'Soft' impacts are much more difficult to quantify, but they can still be hugely significant for the business.  For example, falling revenues may result in disillusionment within the business - a negative cultural impact.  This may result in talented individuals leaving the business, which could lead to a self-perpetuating cycle of decline (a strategic risk).  Quantifying impacts financially helps to express the significance of 'soft' impacts in terms that everyone can understand, putting them on the same basis of credibility as 'hard' impacts.

As with probabilities, complexity also adds to subjectivity:

• range of impacts:  impacts can affect many different areas of the business, making it hard to gauge the total impact.
• interdependence:  one impact may result in another impact in a different area of the business
• lack of precedent:  the situation may be unprecedented, or the precedent may be far in the past, making it difficult to assess the likely impact today.

Understanding IMPACT of a decision

Probability is the likelihood that a particular outcome will occur.

Impact is the effect that a particular outcome will have if it does occur.

Impacts can be positive or negative.  We call positive impacts 'upsides' and negaive impacts 'downsides'.  A single decision may involve the potential for both upsides and downsides.

Considering impact helps us

• weigh up different possible outcomes against each other,
• to assess how bad they will be for the business (if they are downsides), or
• how much benefit they will realise (if they are upsides).

We can think of impacts as 'hard' and 'soft'. 

'Hard' impacts affect areas of the business such as:

• financial:  losing or making money; changing profit margins; changes in share price
• performance:  changes in turnover; changes in business volumes; problems with quality, or improvements; losing or gaining customers; growing the business or seeing it decline
• business continuity:  whether business operations can continue when problems arise; whether new demands, or peaks in demand, can be met; the availability of business-critical systems
• individuals and groups:  physical safety; financial status and reward; working conditions; workload; level of responsibility; status and authority; prospect for the future.

'Soft' impacts affect areas of the business including:

• reputation and brand equity:  how the business, its products or services and its actions in society are perceived in the wider world
• morale and motivation:  how people feel about working for the business
• faith in management:  whether people believe in mangement's abilities and vision for the future
• sense of community:  whether people identify with the business and its aims and fell part of the business's culture
• social standing:  people's sense of value or relevance to the business; their sense of authority or power.

Subjective Probabilities are an unavoidable part of decision making

Subjective probabilities are an unavoidable part of business decision making. 

You often have to make an opinion on strategic issues facing your business.  For example, you may be setting the five-year plan for your business.  You would have to assess all the factors which could have a big impact of the industry in which you operate in.

The situation is very complex. Your partners have different views and may not reach agreement.  On top of that, other industry leaders are making their views and this may have an impact. 

All these complexity doesn't prevent you and your partner from forming a view - maybe nothing more than an instinct or a hunch - as to what is going to happen.  Perhaps, you both agree that it is "quite likely" that a certain factor will impact the industry in the next two years.  Since this is of strategic significance to the business, you will need to accomodate this in the planning.

As you and your partner put your thoughts down on paper, what exactly does "quite likely" mean?  You may think it means "almost certain", while your partner considers it means "fifty-fifty".  In other words, you think "quite likely" equals a probability of (say) around 95%, while your partner assumes it denotes a probability of around 50%.

How can these two views be brought closer together.  Perhaps, they could use a probability that is objectively knowable - such as the throw of a dice - for comparison.  Do you think that such and such a factor is more or less likely to occur than throwing a six?  If less, the probability is lower than 1 in 6 (0.166).  If more, the probability is higher.  By discussing the issue in these terms, you and your partner can move closer to a picture of probability that you both share - and one that you can communicate with some degree of confidence.  You can both use this information to help pin down this probability - combined with your own opinions, experience and intuition. 

Let's assume you and your partner agree on a probability of 75% that a certain factor will impact on the business within the next two years.  It is important to note that just because two people have agreed a figure, the probability hasn't become any less subjective.  Using numbers adds clarity and precision but does not necessary indicate accuracy.  In your written report, you and your partner will need to explain the facts and reasoning behind your probability calculations, and stress the fact that the probability remains subjective even though it has been expressed numerically.  (You might use a range, such as '70-80%')

Some decision makers may regard this as pointless - how can that help you make a decision?  If you can't know probability objectively, why waste time trying to quantify it?  The answer is that it doesn't help you make the decision, but it does focus attention on the objective basis (if any) for assessments of probability.  It forces you to bring your information, reasoning and judgements into the open, so that others can see them. 

In the above example, you and your partner are forced to reach a shared understanding of probability so that you can communicate it and also, to others in your report.  While this doesn't necessarily makes it easier for you to make strategic decisions, it does mean that whatever decsion you take will be based on the facts that are available - or draw attention to the need for more facts.  Expressing probability numerically is also likely to focus everyone's minds on the urgency of the issue, rather than letting them adopt whatever interpretation of "quite likely" suits their own values and priorities.

Another benefit is the potential for sensitivity analysis:  to assess how the impact of a particular risk changes with respect to changes in probability of a particular factor.  Bigger changes mean higher sensitivity.

To measure risk we have to use probability

To manage risk, we have to be able to measure it, and to measure risk we have to use probability.  Probability is the quantitative language of risk and uncertainty.

The probability of an outcome is a number expressing the likelihood of it actually happening.  It can be a number between 0 and 1, where 0 indicates an impossible outcome and 1 a certain one, or it can be expressed as a percentage (a number between 0 and 100).

In some situations, probability is objective and factual.  For example, the probability of calling the toss of a coin correctly is 0.5 or 50%.  However, tossing a coin is a very simple event.  It is easy to use past experience and real-world knowledge to assess the probability of a 'heads' or 'tails' outcome. 

As situations become more complex, it becomes progressively more difficult to be objective about probabilities; they become more subjective.  Business situations are extremely complex, and therefore the probabilities involved are highly subjective. 

Because the decisions we make in business are so important, it is vital to try and pin down the probabilities involved, even though it may be impossible to achieve complete objectivity.  The more precision we can bring to the situation, the firmer the foundation on which we make a decision.  To move towards precision, we need to look at subjective probabilities.

Premature fiscal exit would hurt Malaysia, says World Bank

Wednesday November 18 2009.Related Articles

Premature fiscal exit would hurt Malaysia, says World Bank
KUALA LUMPUR, Nov 18 — The World Bank warned today that Malaysia should not exit its fiscal pump priming as it could choke off the country's economic recovery.

However, the bank also cautioned that extending fiscal support for too long "may hamper the credibility of medium-term fiscal consolidation, reduce room for future stimulus, increase the risk of asset price bubbles and constrain the private sector once demand picks up," the World Bank said in a country report on Malaysia.

Malaysia is expected to rack up a budget deficit of 7.4 per cent of gross domestic product this year, its biggest in over 20 years, in part due to two fiscal stimulus packages worth a total of RM67 billion.

The extra spending was aimed at offsetting a slump in global demand that has hit Asia's third-most export dependent economy hard.

The government expects the Southeast Asian country's economy to shrink 3 per cent this year and to grow by 3 per cent next year, although the World Bank was more optimistic.

"With East Asia leading the recovery and advanced economies showing progressive improvement, the Malaysian economy is projected to grow at 4.1 per cent in 2010, following a contraction of 2.3 per cent in 2009," the World Bank said. — Reuters