Finance: The fallout after the gold rush

Business is often a gamble but too often investors risk finance without weighing up the dangers.

BUSINESS, AS anybody who has been involved in a start-up knows, is largely about risk. It is all very well envying the success of investors in Microsoft and Intel, but back when these corporations were just gleams in the eyes of their founders, putting up the money to turn those dreams into reality involved a lot of risk.

For this reason, it is not always possible to be sympathetic with the "victims" of corporate collapses. Investing in stock markets is - as the small print now points out - an inherently risky business.

But it is not just individuals who get caught out in this way. You have only to look at how insurance companies - which might be expected to make risk a core part of their business - howled with pain when the sharper- than-expected downturn in the UK housing market in the early Nineties led to correspondingly large pay-outs on mortgage indemnity policies issued when the market was booming in the Eighties.

Or there is the situation in the Far East, which only a short time ago was regarded by many companies as a land of limitless opportunity, but is now seen as an extremely dangerous region for investment.

If such mistakes are happening on such a scale, then maybe the conventional models for assessing risk are inappropriate. This is the argument of Ron Dembo and Andrew Freeman, a risk-analysis consultant and financial journalist respectively, in their book Seeing Tomorrow (John Wiley & Sons, pounds 19.99). As the subtitle Rewriting the Rules of Risk indicates, they are setting out to improve the ability to make important decisions and - accordingly - change the way in which investments and other financial decisions are made.

Much of their focus is on the business arena. They explain how even George Soros slipped up when he became involved in a property development with the Reichmanns in Mexico City that failed to go ahead as envisaged after the country's economy hit a downturn. But they also explain how their approach may apply to the housing market, where even they found themselves caught out by the cycle.

At the heart of their theory are the related concepts of "upside" and "downside", or, as they term the latter, "regret". Essentially, risk is all about analysing a situation to see if "U" outweighs "R". Regret, they argue, is more useful than existing risk measures because "it can reflect our appetites for risk".

To understand this better, they introduce the concept of "risk-adjusted value - value that has been altered to take into account our personal attitude towards risk". Recognising that we are more prone to risk in some circumstances than in others, they have come up with a "risk aversion constant" that they give the Greek symbol, lambda.

"Another way to think of lambda is as a margin or insurance premium that we might decide to put against our possible losses, in the event that our upside fails to materialise," write Dembo and Freeman. "The larger the value for lambda, the more risk-averse the decision maker, because he or she is paying a higher price to self-insure the risk."

Pointing out that most of us are risk-averse, they add that another way of putting this is to say that most people would like to have the assurance that they have set aside enough funds to protect their downside. Hence the oft-repeated warning to stock-market investors and casino gamblers alike not to bet more than they can afford to lose.

But, though the language is full of complex mathematics, what they are really getting at is the need to think more clearly about risk. Too often, people - whether acting in business or as individuals - seem to pay insufficient attention to weighing up the pros and cons of situations.

Even supposedly sophisticated organisations often fall in with the herd mentality rather than making their own analyses. Hence, so many banks were left nursing substantial losses when the commercial property market collapsed. They all followed each other into a market that, though it started out lucrative, quickly became catastrophic.

Similarly, many Lloyd's Names were caught out because past performance had indicated that becoming a member of an insurance syndicate was a certain way to make even more money than they had already. Of course, if they had thought about the true nature of what they were entering into, it would have occurred to them that the downside of making lots of money was the risk of losing even more.

But it is not just that people and businesses can get carried away by the Upside. They can also, as David and Jim Matheson, the authors of The Smart Organisation (Harvard Business School Press), point out, react in knee-jerk fashion to bad news.

Accordingly, they say, the turmoil in the Far East's financial markets is not bad news for everybody. While companies might want to be wary of becoming involved in public-sector projects or initiatives that require investments from indigenous companies, they can - for instance - find cheap manufacturing opportunities.

With the Mathesons convinced that what really sets apart the great businesses is an ability to make the right decisions, a model that offers a better understanding of the nature of risk could well fall on fertile ground.