The world is becoming an increasingly complicated place. Given how globalized the world has become and the unrestricted flow of information, making decisions in organizations is difficult. But Professor Hersh Shefrin’s course on behavioral risk management at the Amsterdam Institute of Finance will help academics, corporate professionals and the public to navigate complex environments.

There is a common thread to some of the world’s major disasters such as the 2008 financial crisis, the Deepwater Horizon oil spill in the Gulf of Mexico in 2010 and the explosion of the Fukushima Daiichi nuclear reactor in 2011.

Psychological issues and influences were at the heart of these disasters because humans had to make decisions, which sadly led to colossal failures and fatalities. They are also a reflection of the fact that humans can sometimes be unpredictable, rash and foolish.

Professor Hersh Shefrin: ‘Behavioral risk management

At the end of the day, these disasters were about whether humans calculated risk factors adequately before making decisions in a workplace setting. After all, the global financial crisis, oil spill and nuclear reactor explosion all happened in a workplace or organizational setting.

Managing workplace risk factors is a research discipline known as behavioral risk management. It is a topic that fascinates Dr. Hersh Shefrin, an economist who has built a four-decade-long career on understanding behavioral risk management and complex human behavior.

As Shefrin puts it: “Behavioral risk management is central to the way the world works. I’m interested in the way the universe works. I have a natural tendency to wonder about the universe.”

Shefrin has been a pioneer in this discipline, exploring issues such as ethics, risk management, and self-control. In September 2019, he will deliver a course on behavioral risk management at the Amsterdam Institute of Finance (AIF). In this interview, Shefrin explores what behavioral risk management entails, how it has evolved and what attendees of his course can expect.

AIF: At first glance, behavioral risk management seems like jargon used by corporate professionals to sound fancy. What does it refer to and entail?

Shefrin: Risk management is now a field within both financial firms and operating companies. In financial firms, there are people, whose official jobs are to focus on risk management. Essentially, they are risk managers. For the most part, their task is to assess the risk(s) that companies face in order to provide information about risk exposures and help decision-makers in companies such as board members and senior management. Risk managers do not make decisions, but they are assessors of risk. They focus on specific risks such as foreign exchange, market, and safety risks. Other risk managers are tasked with overseeing a broad set of risks that companies face.

Then there is the behavioral part; behavioral is a code word for psychology. It is about how psychology influences and impacts the way in which judgments and decisions are made about risk. The behavioral approach to risk management begins with the quantitative part and then injects the psychological component so that assessors of risk, and people who make decisions about risk, are aware of the psychological influences that impact their respective activities. It is about blending the qualitative behavioral component with traditional quantitative risk management tasks. The qualitative viewpoint complements the quantitative.

AIF: How will you approach the topic of behavioral risk management in the course?

Shefrin: The psychology begins at the level of the individual. So, the course will begin by focusing on our own personality traits. It is very personal. We want to understand how these psychological traits impact us in our roles within organizational settings. It is about what we do as individuals in organizations and how we interact with others within groups. This approach leads us to the question of whether organizations have personalities and cultures of their own, reflecting the nature of the way that risk decisions and judgments about risk management are approached.

AIF: Courses can get theoretical and esoteric. Will you focus on case studies during the course to make it more relatable?

Shefrin: The course will focus on case studies and we will get into the nuts and bolts of what behavioral risk management means. I will demonstrate that behavioral risk management is not some abstract concept. I will use my own book, which is titled Behavioral Risk Management: Managing the Psychology That Drives Decisions and Influences Operational Risk, to guide the course. I begin in the book by saying that what we want to understand is that every major risk management disaster in the last 20 years has psychological roots at its core. If you want to understand what went wrong, it wasn’t so much about the failure of some quantitative technique, but instead some psychological concept and driver, which induced behavioral patterns that led to a disaster.

I will certainly talk about cybersecurity and cyber risk, which is a 21 st century issue. I will talk about cryptocurrencies and climate change. All of those are concepts that are important in the 21 st century and deserve more exposure.

AIF: It seems like behavioral risk management has historical roots in the field of psychology and economics. In which field does it best fit?

Shefrin: It fits in both economics and psychology. The Greek philosophers were the first to identify the notion of rationality and to say a rational person knows the ends they want and is able to identify the best needs to achieve those ends. That notion of rationality became known as the classical notion of rationality. That concept pervaded Western thought as Adam Smith was familiar with it. He is regarded as the world’s first economist because before his writing, economics was part of philosophy. Adam Smith was not known as an economist; he was known as a moral philosopher. He published two major works, The Wealth of Nations and The Theory of Moral Sentiments, which defined modern economics. Smith talked about the psychological influences on people before there was a notion of people because psychology was also part of philosophy. John Maynard Keynes [an economist] was a brilliant academic and moved in an intellectual circle that read Sigmund Freud, who was a pioneer of psychology.

Keynes was open-minded enough to incorporate psychological concepts into his 1936 work, The General Theory of Employment, Interest and Money. Moreover, Keynes wrote about psychology but he didn’t talk about risk management. He talked about the broader risk. Looking at Keynes’ work today, we can say without doubt that he was a behavioral economist. In the middle of the 20th century, economists decided that they wanted to approach economics in the same way that physicists approached the physical world. They wanted to use mathematical techniques, and this actually drew me into the field of economics.

AIF: And behavioral risk management has evolved into a distinct field. What else drew you into it?

Shefrin: I was captivated by the idea that you could analyze economics in the same way that could analyze physics. What I didn’t understand, which took me a while to understand, is that the economists who did this stripped out of psychology. They thought you could replace psychology with a mathematical model and ignore what psychology tells us about human behavior. Psychology disappeared from their writings. The reason there has been a resurgence of psychology is that critical psychologists such as Daniel Kahneman and Amos Tversky figured out what economists were doing and set out to show them what they were missing. They provided economists like me with a conceptual framework and set of tools to bring psychology back into our world views.

AIF: What was your focus in exploring behavioral risk management and behavioral finance?

Shefrin: As best as I can tell, my colleague Richard Thaler and I were the only people doing behavioral economics in the mid-1970s and were certainly the only ones speaking with Kahneman and Tversky in the 1970s. We took their ideas and started to put them back into economics and rebuild economics from the ground up so that the psychological concepts were incorporated. As we were joined by other members of the profession, slowly but surely, people were persuaded to take the psychological approach seriously. That coupled with seeing how irrational the world is when we look at the eruption of the global financial crisis. That convinced a lot of people that there was something important to be gained by giving full weight to the psychological approach.

AIF: What do you hope attendees of the course will take away at the end of it?

Shefrin: Firstly, to be familiar with the vocabulary and words. Secondly, they should have narratives that they can attach to the words so that they know how to recognize psychological patterns when they see them. The third is to understand how those psychological risk management ideas work together with the quantitative techniques that they use today in their professions. If you look carefully at recent disasters such as the Deepwater Horizon oil spill in the Gulf of Mexico, the Fukushima Daiichi nuclear reactor meltdown, and global financial crisis, we can see that there are psychological issues at the heart of all of them. If we understand them, maybe we can reduce the risk of those events. We may not eliminate their occurrence, but we can reduce their magnitude when they happen.

Join ambitious professionals for the two day ‘Behavioral Risk Management program, taught by Professor Hersh Shefrin (Santa Clara University) at Amsterdam Institute of Finance.

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