Re:Balance -- Jim Peterson

Risk Assessment and Priority Setting -- When Word of Mouth is All the Recommendation You Need

Belated thanks for the interest and uptake on my post of June 20, on the dispiriting June 3 meeting of the US Treasury Department's Advisory Committee on the Auditing Profession -- here. I've fallen a little behind, having spent all last week working in Europe, where there are some very interesting developments involving the regulators. I'll be coming back to those, after a break for the Fourth of July.

Meanwhile, on a subject that lies behind my primary attention to financial and accountancy matters -- that is, the personal challenges to good risk assessment and priority setting -- I've been working to design a business school course on the tools and methods for choice-making, especially under the constraining limits on knowledge or resources.

A while ago I wrote about my skeptical attitude about casino gambling -- here. The related column below is from the International Herald Tribune of February 23, 2007. Reactions, and ideas for other teachable examples, are invited and welcome:

I recently needed help in choosing a good restaurant in New York. I am not current on the hot dining spots, so — as is typical in the process of daily decision-making — I had to sort and evaluate among competing alternative sources of advice.

The local version of the venerable Michelin red guide is struggling to establish itself in the Big Apple. Against it, the populist little purple Zagat Survey — born as a mimeographed collection of short-take amateur reviews by friends of the eponymous Tim and Nina Zagat — dominates the field.

Why is this? And what does the attempt to bring order among a multiplicity of influences have to say about priority-setting in a world of too much information and not enough certainty?

In one view, perhaps Michelin suffers from a Francophobic backlash against its expert-based star rating system and a century of make-or- break reputation effect in Europe.

Another view, just as likely, is that Zagat users take comfort in input based on common tastes and assumptions about price, quality or status. A Eurocentric critic of haute cuisine is assumed to have tastes that do not match ours. But if a broad sample of "people like us" finds a choice to be congenial, how wrong could we go?

Word-of-mouth has long shaped the successes of movies, music and fashion. Exploiting the principle, marketers in the world of electronic commerce are tracking the footprints of consumers. No sooner do you click-to-buy the Amazon book or the Orbitz vacation ticket than a pop-up appears: "Others who enjoyed your purchase have also bought all this other stuff."

Restaurants achieving favor with the Zagat reviewers tend to keep their high places on its popular list through a self-reinforcing circularity of fan support. Choices are validated by a vague and fuzzy sense of community that is both virtual and thoroughly artificial.

There are two related limitations on this consensus approach. The first, in the lingo of the game-theoreticians, is that of salience — the degree of importance, and especially the consequences, if the decision goes wrong. With standards that are subjective, the concept of a "good" dinner is elusive. But where the extent of commitment is limited to the price of a meal, the consequences are transitory and the downside is modest.

As a check on how much priority- setting can be done this way, think how tolerant we are of weather forecasters. They hang out their predictions every day, but they are never held accountable for the fickleness of actual outcomes. Because who really cares? For most of us, a surprise shower without an umbrella means at worst the discomfort of a change of wet clothes.

But for some people and in some cases, the degree of weather-prediction salience could be very high. Think of the impact on the launch of a space shuttle or the timing of a crop harvest or the order to evacuate before a coastal storm. When it is critical, decision makers will search well beyond the evening news or the farmers' almanac.

And that's the second limitation on consensus: when high-salience decisions demand high-level expertise.

Airline passengers may well consider each others' views about the choices of in-flight meals. But they are not invited to take a poll on the preferred way to fly the airplane. Likewise, hospital emergency room patients are not treated by popular vote, but under the leading judgment and expertise of the trauma surgeon. "Close enough" and "good value for the price" are not satisfactory performance standards for landing an Airbus or performing the Heimlich maneuver.

A hazard in daily life lies in sorting out what really matters from what doesn't. If a wardrobe advisor gets a style fad all wrong, the downside is an ill-considered garment that goes straight to the charity bin. But if an investment adviser gets a market trend or a sector swing all wrong, the downside could be a multi-decade asset impairment.

Taking a brother-in-law's hot tips on a wine choice can't cost very much, and might be good for family relations. Taking his hot tips in managing a retirement fund, on the other hand, could be hazardous to financial health.

External oversight can provide some help. We assume the competence of the airline pilot, without an interview about training and license; same for the bus driver and the pharmacist.

Still, as President Ronald Reagan advised when dealing with the Soviet Union on disarmament, "Trust — but verify." Which is why we'll compare among our friends' dining experiences, and why second opinions are commonplace in medical systems that are privately administered and insured.

Is there the same rigor in financial management decisions? A host of important choices might be candidates for second opinions: the size and structure of insurance programs, the details of estate plans, the percentage allocations among portfolio sectors, the deployment details within sectors.

The investment professionals do it, we know for sure. The awe-inspiring performance of the university endowment funds owes in good part to aggressive, hands-on maintenance of programs divided among advisers who compete for results and favor. How many of us are willing to do the same? It's a good guess that more energy goes into surveying our friends as to where to dine out.

Speaking of which, my hotel concierge in New York got me a table in an unreviewed little place down the street. I wouldn't have sought or taken his word on my retirement account. But acting on his advice and influence, I ate contentedly and well — which was all I could expect.

Risks and Choices -- Managing the Odds in an Uncertain World

A while ago I set out with my editor at the IHT to broaden out beyond the financial and accountancy issues on which the "Balance Sheet" column has focussed since its launch in 2002.

The broader premise was that life involves the constant need to make complex choices, with real consequences, based on incomplete information. Even when priorities are unclear, or head and heart are in conflict, there are useful tools and methods to help. Instinct is not a substitute for ignorance.

Space constraints in the newspaper meant that we didn't get far. But the topics remains worthy of consideration, so I propose to offer the occasional essay here. Your reactions are welcome and invited -- by comment or e-mail -- including ideas for other topics.

This column was originally published in the International Herald Tribune on February 2, 2007.

Vegas is No Fun Once You Know the Odds

It's a little complex to explain, without sounding like a complainer, why my recent weekend in Las Vegas — a first-time trip — will also most likely be my last.

A dozen of us gathered to celebrate a friend's major birthday. Our host chose the venue, and who could possibly complain? We had comfortable rooms, abundant food and drink, a poolside cabana with attentive staff - all the essentials for good friends to enjoy each other's company.

Thankfully for our purposes, the larger Vegas ambiance was irrelevant. Compared to its relentless marketing and bloated artificiality, the world of Disney would have looked positively real. When we wandered for breakfast into the Parisian Hotel, past the faux Eiffel Tower and into the disinfected bistro, our waiter actually was a 20- something from Lyon on a year's leave in the United States. We could have kissed him for his authenticity.

In its blandness, Vegas has nothing left of the edgy and faintly sinful style of its bygone era. Our parents' generation dressed up, flying with airlines that still served meals with linen and crystal. They may have left their holiday budgets at the gaming tables, to be laundered in the cash rooms for the benefit of sinister figures from Chicago or Cleveland. But they enjoyed the frisson of tipping a dinner-jacketed captain for improved cabaret seats to hear Frank or Sammy.

I'm not choosing for anybody else. There is a huge, popular market for the over-the-top architecture, the theatrical light and water shows and the ear-splitting night-life sound systems — at least to judge on our Sunday departure amid the enormous worse-for- wear crowds choking the grubby third-world chaos of McCarran International Airport.

I just couldn't get the casinos. Still at the core of Las Vegas, they support the entire structure of phenomenal staff and overhead expense, through the remorselessly grinding odds by which the lavishly appointed houses so plainly always win.

There are two reasons I find no appeal in gambling. Neither is judgmental of those who do take pleasure at the tables — just as long as they don't try to convince me that they have somehow out-smarted the inevitable effects of long-term probabilities.

We all make choices and set priorities every day, from vital to frivolous — weighing risk against reward, and assessing cost against benefit. As often as not, gut instinct or the heart's inspiration prevails over what the head well knows. And that's fine. The scientists explain that the reason we still make odds-defying decisions is that to survive as a species, our prehistoric ancestors' DNA triggered split-second reactions to the giant wolves and saber-toothed tigers.

With the slow pace of evolution, we are little different from the first cave- dweller who grunted optimistically that his drinking gourd was half-full, not half-empty. Except that now it's hardly ever a life-or-death decision whether to press a bet or split a pair. Instinct is wrong too often to be a comfortable substitute for ignored information.

My first concern is that I've devoted a career to the management of my client's risks and exposures. It's my business to hazard big- money consequences on being right or wrong.

With that as a day job, even if not as hazardous as the caveman with only his club against a mammoth, my view of a blackjack table is that it just feels like more work. And unless they're addicted to the rush, crisis managers and first responders — air traffic controllers, paramedics, hostage negotiators — might feel the same, or at least that's how I'd bet it.

Second, success in making calculated predictions based on incomplete information includes paying close attention to knowable adverse odds. I'm as eager as the next guy to have Lady Luck hold my hand and whisper in my ear. But believing that fortune favors the well- prepared, I can't help thinking that it's a poor proposition — and perhaps an affront to the Lady herself — to play against the inexorable probabilities built into the zeros on the roulette wheel or the 7s and 11s at craps.

Life is full of choices made against the teachings of well-known probabilities. Otherwise, whole industries would disappear. If informed rationality strictly ruled, there would be no day traders, nor mutual fund salesmen; convenience stores would be unable to sell the calculable losses of either cigarettes or lottery tickets; no more would appliances be sold with extended warranties, nor vacation homes built on sand bars or flood plains.

My friend Bill, a banker, perceptively puts it that as the caveman's fight-or-flight instincts apply to our modern time horizons for risk aversion and deferral of gratification, the ancient DNA hard-wires us for the adrenaline jolt of the turn of a card or the tick of a stock price.

If Bill is right, and I suspect he is, that would go a long way toward explaining why it can be so hard to defer satisfaction for the long view — to contribute to a private pension plan, or save for a child's university tuition — especially when there is a more remote and seemingly less painful way of achieving the same end -- whether Social Security or college loans.

So on one hand, I understand and am not really against the idea of a Las Vegas holiday built on dreams uninfluenced by reality. That's the very sustenance of such an oasis in the desert.

But for me, the reason to go there — carefully keeping my wallet in my pocket and my hands off the dice — was more concrete: to wish my friend a happy, healthy, and very lucky birthday. Although, while waiting for another such occasion, I will check the point spread if ever the Chicago Bears are again in the Super Bowl.