Risk Perspectives: Averages vs. Tails

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In the wild world of global economics, risk seems to be around every corner. Some identify risk as the volatility in everyday things such as weather, markets, etc., while others focus on the black swans, or the unusual events. Regardless, each poses a threat and opportunity to profits and wealth management. Let’s drill down a little deeper and examine risk.

A speaker on a recent program put an interesting twist on risk. Referring to a standard bell curve, he stated that risk is not in the averages, but risk is the tails, or at the extremes. His example was a banking situation. The average loan in the portfolio was $300,000; however, it was the $30 million dollar loan, or the extreme, that if not properly managed could be the one that takes down the bank. In the same light, it is not the corn or soybean prices, or input costs, that are in the normal deviations that play havoc on business sustainability. It is when these input and price structures are driven to the extremes and stay there for an extended period of time, or when they converge together that havoc ensues.

Also, he stated, it is rare to know the risk that will get you into economic or financial difficulty. Case in point, in my speaking tours everyone will ask if agriculture will experience a repeat of the 1980s with similar conditions leading to the downfalls. The answer is yes, if events converge together, combined with that black swan unplanned event. The unplanned event could be a trade sanction, a dramatic shift in the emerging economies, or major regulatory adjustment. The major surprise could be pandemic outbreaks, disease in the livestock sector, a terrorist attack, or natural disaster, which are all unpredictable events that are major game changers.

How do you mitigate these risks? In his new book, Great by Choice, Jim Collins and co-author Morten T. Hansen, state in an uncertain world of risk and volatility, 10Xer companies – i.e., ones that historically beat out others in their industry by a 10-fold factor – maintain high amounts of cash reserve and liquidity for a financial shock absorber but flexibility to adjust to the tail risk.

P.S.: I highly recommend Great by Choice as a follow-up to Collins’ book Good to Great.

 

Editor’s note: Dave Kohl, Corn & Soybean Digest trends editor, is an ag economist specializing in business management and ag finance. He recently retired from Virginia Tech, but continues to conduct applied research and travel extensively in the U.S. and Canada, teaching ag and banking seminars and speaking to producer and agribusiness groups. He can be reached at sullylab@vt.edu.

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