From the June 2007 issue of Treasury & Risk magazine

Those Unsung Stats

Good risk management, in whatever form it takes, is about increasing the company's ability to hit its goals. For example, the attempt to avoid large losses serves to prevent the kind of adverse impact on the finances of the company that will cause it to miss its targets. Likewise, sophisticated models predicting market or price fluctuations allow the company to plan, invest and hedge in such a way that reaching a goal, if not assured, is more probable.
It is often thought that in order to achieve this kind of security, one must trade some upside benefit. This is not always the case. Oddly enough, professional baseball has shown us how knowing the odds and tilting them in our favor can produce fantastic outcomes without trading away any upside potential.

For example, in his book Moneyball, Michael Lewis examines how the Oakland A's have been able to produce consistently excellent results with far less money than their competitors. The manager of the A's, Billy Beane, realized that the market overvalued certain statistics for certain players, such as RBI's, and undervalued other more important statistics. By carefully modeling the correct statistics, he was able to purchase players that were technically undervalued based on these new calculations. He understood that the investment in a player is much like an investment in the market. If he could focus on metrics that indicated a player's success or failure (loss versus gain), he would have a better probability of hitting the performance goals he had set.

Pulling together all of the players into a team is very much like aggregating investments into a portfolio. If each bet is taken wisely, and weighed against the attributes of the other bets and decisions based on the portfolio risk, one can predict with reasonable certainty the range of probable outcomes. This is exactly what Beane did. By measuring the probability range of outputs for each player and then aggregating them, he was able to predict with surprising accuracy whether or not the A's would make it to the play-offs. It put Beane at the top of his division and cost less than half of what his competition spent.

Baseball and running a company might seem to have very little in common. However, in both, the key to success is not only in setting reasonable goals; it is also in determining which factors really drive the variations between hopeful projections around goals and the actual outcomes. As in baseball, the wrong stats can distract companies.

For example, a single-minded focus on the events and activities that impact revenue can be a distraction if costs are rising out of control and the metric that best predicts success is net profit. By controlling and managing the salient factors that impact important outcomes, we can greatly decrease variations from those outcomes and increase the chance that key objectives will be achieved. While this practice goes by many names, the most accurate term for it is "good risk management."

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