Wednesday, June 20, 2012

Risk and Reward

With my absence in writing for a couple of months, you could believe that I haven’t been thinking much about the ideas that I write about here at Plan B Philosophy. In reality, there is nothing further from the truth. I have so many ideas for blog posts that sometimes I don’t know where to start.

But a few events during the past month have spurred me on to write. The event I want to focus on is multi-billion dollar trading loss by JP Morgan Chase and subject of risk. This loss happened as a result of a highly complicated trading scheme that had JP Morgan trying to mitigate risk in their portfolio by taking a bet on the European economy.

The media was *shocked* by this event. It was seriously reported for about a week and JP Morgan Chase CEO, Jamie Dimon, testified in front of Congress. With an upcoming election and the political implications of the Volker Rule, we will probably hear about this for some time to come.

Putting aside the actual issue, the media reaction amazed me. While Dimon called it a colossal mistake because of oversight reasons, let’s be clear - the job of a bank is to take risk. It borrows money from its customers in the form of deposits, and makes loans and investments that need returns which exceed the cost of deposits. While the global financial markets are obviously more complicated than that, JP Morgan takes an assorted amount of risk every day. Its losses from this event equal less than 1 percent of capital and .01 percent of deposits, and apparently no insured deposits were used in the trading. They were clearly on the wrong side of the risk, but the risk itself wasn’t huge in relation to the assets and capital of the bank.

To JP Morgan’s credit, they faced down the issue, admitted they lost on a bet (even if Dimon said it was stupid and a few billion dollars is a real number to people like me that don’t work in “billions” very often) and vowed to move on.

In my experience, people (especially the media) want to talk and celebrate the reward of taking risk but are rarely prepared for the downside. We celebrate the risks people take. We celebrate those on the edge and then just as easily look at them sideways when risks turn out to be real and some sort of failure ensues. The first impulse is to explain just how inept these people were because they took a risk and failed.

I work in a highly regulated industry – financial services. It should be highly regulated as we all need to be confident that our money is safe and sound. But let’s face it – companies and industries that don’t take a little risk won’t survive very long. When someone hits it big, they call that innovation. When they take a chance that doesn’t pay off, it gets called “risky.” Victory has a thousand fathers, defeat is an orphan. Few people talk about Steve Jobs at NeXT, but they glow about his work at Apple. Or as they say in the banking business, “No one has ever made a bad loan. They just go bad after you make them…”

And it is certainly easier NOT to take a risk  -  just to say “no.” You never have to face the second guessers, the Monday morning quarterbacks who say, “I knew it would never work, but (fill in the blank) just wouldn’t listen to me.” But the world is only changed by those that don’t freeze up in the face of risk but try and find ways to smartly manage it. America would have never sent a man to the moon without the chance that the rocket that would take us there could blow up. Every astronaut has faced that reality when they stepped into the rocket. History shows other examples as well. Many of the inventions and breakthroughs that we take for granted took an individual or small group stepping out into the risky unknown to try something new that people thought would never work. Those that succeed are famous; those that did not succeed are not. Yet the effort and courage between both are many times the same.

So that brings me back to JP Morgan. They took a risk and lost. In fact, they lost a lot of real money. But think if this hedge had been successful. Few people probably would have ever known and maybe a small team would have seen a larger bonus at year-end. In the end, JP Morgan might have had sloppy procedures and oversight. But they admitted it and moved on to protect against risks that are outside of their tolerances. They were in the financial position to weather the storm and will hopefully not overreact and discourage risk taking that is within their tolerance.

Risk is easier to evaluate in finance and sports than in the rest of life. When New England Patriots coach Bill Belichick decided to go for it on fourth down a couple of years ago to keep the ball away from Peyton Manning and failed, there was plenty of second guessing. But if he goes for it and succeeds, he is a genius all-around. The play is the same. The outcomes are clearly different. But the courage that it took to make that strategic calculation in that moment didn’t change based on the outcome.

One of the most famous quotes on risk taking is from Theodore Roosevelt. You have all probably read or heard it at some point:

“It is not the critic who counts: not the man who points out how the strong man stumbles or where the doer of deeds could have done better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood, who strives valiantly, who errs and comes up short again and again, because there is no effort without error or shortcoming, but who knows the great enthusiasms, the great devotions, who spends himself for a worthy cause; who, at the best, knows, in the end, the triumph of high achievement, and who, at the worst, if he fails, at least he fails while daring greatly, so that his place shall never be with those cold and timid souls who knew neither victory nor defeat.”

In my mind, the most interesting part of the phrase is, “who errs and comes up short again and again, because there is no effort without error or shortcoming... and who, at the worst, if he fails, at least he fails while daring greatly” That is the essence of risk-taking, success and competition – the willingness to step on the field or in the arena with a very real probability that you could lose but all the while focused on daring greatly.

In the end I suppose, history will always be written by the winners. Those who take a risk and win will be exalted; those that take risks and lose will be written off as substandard in some way. But I think a more accurate picture of the truth is that there is often only a narrow difference between success and failure, and often it is determined by circumstances beyond our control. We take risks and sometimes fail. I believe to invent the future we must have to have a tolerance for risk and the potential for failure.