Confused? You should be

Is there any risk jargon more confusing than terms to do with risk appetite, tolerance, acceptability, and all that goes with them? I doubt it. At first glance they seem clear enough, but after a few moments a clear thinking person will start to wonder why an analogy with basic drives like hunger, thirst, and sex is relevant to risk. And when we say a risk is "acceptable" or "tolerable", to whom is it acceptable, in what sense, and why are the phrases so often used with things that are not risk?

Later, as you learn more about the theoretical definitions and their practical interpretations you begin to realise that there are some startling differences in theory and practice.

Not only that but phrases that you may have seen used as synonymous with "risk appetite" turn out to be quite different.

The main purpose of this article is to explain the alternative meanings involved and point out the common confusions. After looking in more detail at why this area has got so confused the article removes that confusion by stating the purpose of the whole effort, then explaining alternative approaches, suggesting more self-explanatory names for each. Various mistakes that can be made are mentioned along the way. There is also a section on common practices and one with suggested improvements.

Why so confusing?

The main reason that this area has become confused is that there are so many ideas being labelled with the same name: 'risk appetite.' However, there is another factor, which is that the word 'appetite' is inappropriate. Specifically, it carries two misleading connotations. The first is the suggestion that people desire risk per se. The second is that 'risk appetite' is a universal part of human make up rather than an intellectual invention.

The idea of appetite comes from thinking about basic human needs like the need for food, water, and sex. If someone has an appetite for food that means they want it and will take steps to get it. It does not mean just that they will tolerate food if it is provided.

In the case of risk things are rather different. When people say someone has an 'appetite' for some risk they almost never mean that person will seek the risk per se; they just mean the person will put up with the risk if suitably rewarded.

For this reason, some people prefer to avoid the phrase 'risk appetite' and say 'risk tolerance' instead, to underline the point that the risk concerned is not in itself desired. (See also Note 1.)

This linguistic trap has been reinforced by two common misconceptions that may be misinterpretations of well known theories about risk.

One of these misconceptions is that higher risk necessarily brings higher rewards. It is true that if you want people to invest in a risky venture then you have to offer them greater rewards as an inducement. (This means, for example, that risky shares on a stockmarket have lower prices as a result so that their dividends represent a higher percentage return. This is famously captured in the Capital Asset Pricing Model.) It is obviously not true that taking more risk inevitably brings higher rewards. Actually it is common sense that doing the same thing in a more risky way usually means lower rewards.

Imagine you must lead a unit of soldiers on a mission across enemy territory. You look at your map to decide on your route to your target and see there are several potential routes that will get you there in good time. However, some are more dangerous (risky) than others. Clearly, taking a more risky route will not improve your rewards.

(Is risk ever attractive in itself? See Note 2.)

The second piece of theory that has muddied the waters is the so-called 'risk thermostat' theory from John Adams. My understanding is that in its more recent version this theory is about trading off risk and rewards, but the name has remained and it is the name that carries confusing connotations. The name 'risk thermostat' reinforces the idea that people seek risk per se, rather than rewards that may justify taking on risk.

The example that Adams has used most concerns the introduction of laws making seatbelts compulsory in cars. The statistics on road deaths tend to show that making everyone buckle up does not have much effect on the number of people killed in their cars and increases deaths among pedestrians. The initial explanation for this under the heading of 'risk thermostat' was that people seek a level of risk while driving and, with the seatbelts added, seek to compensate for the reduction in risk by driving faster.

A more considered version is that driving speed is a trade off between getting to one's destination quickly and being safe. With belts on people feel safer to drive to their destinations that bit quicker, something they usually want to do. The increased risk to pedestrians seems not to be a big concern for drivers.

Unfortunately, the theory's name, 'risk thermostat', has remained and still tends to suggest that there is a level of risk that we like and will seek, even without any other inducement.

The word 'appetite' is also misleading in its suggestion that 'risk appetite' is a basic human drive level like hunger and thirst rather than part of cognitive decision making. It is possible that it is, but far from proven. To me it makes more sense to look at this area as one of human invention — invention of management techniques — rather than theories about human psychology. This is particularly clear when we are talking about an organization's 'appetite for risk' as opposed to that of an individual human being.

Why 'define your risk appetite'?

The purpose of 'defining your risk appetite', whatever that may mean, is to control directly, or at least influence directly, how people make decisions on behalf of an organization in the face of risk and uncertainty by specifying the importance of risk in some way.