Risk Management and Game Theory

risk, risk management, game theoryIn many of our KaizenBiz conversations, there is a reference to how turbulent the business environment is with the rapid changes in technology and access to one another. It is a time when small organizations can be major players in their industry (as noted in Killing Giants by Stephen Denny).  Thus, risk management is on everyone’s mind as they make business decisions for their company.

Definition of risk management

Clearly all businesses face varying types and levels of risk. Risk management is the process to identify, evaluate and plan for factors that could pose harm or obstacles to the organization.

Where game theory fits in

Many people are familiar with the “prisoner’s dilemma” which is one aspect of game theory. But game theory is more involved that just that one aspect. However, at its most basic level, it is the idea that people and organizations take into consideration benefits and risks to make decisions on what they perceive to be in their best interest. It is important to remember that there is an assumption of rational thought behind process and the decisions within situations of competition, conflict, cooperation and interdependence.

Game theory can be useful within business planning and risk management is how it illuminates connections between disparate information and provide discoveries about how trends could turn out in the future, how competitors might behave and propose multiple scenarios.

But real life is messier than academic scenarios

The Wall Street Journal reported on November 6, 2013 that in a national survey conducted by TD Bank “that middle-market and corporate CFOs are more confident about both their organizations’ ability to manage financial risk and the financial prospects for their companies, indicating the potential for increased business investment in the months ahead.” This apparent increased tolerance for risk may be another indicator of economic growth. Even so, some of the risks that are still prominent for decision makers are political uncertainties, cash flow and liquidity, emphasis on being innovative, potential interruptors from natural or human elements and sluggish economic growth.

The fly in the ointment for game theory

Since game theory presupposes that the people involved will make decisions from a rational basis, this makes things interesting. Now what is often overlooked is that rational in game theory is really about showing a transition from one  point to the next. For most decision-makers, they have a passing understanding of game theory and how it relates to the process of planning.

The challenge with risk management is trying to anticipate and set up a plan for those potential scenarios. The way game theory could be useless is in what Rob Duboff calls “atmospherics.” According to Duboff, there is a signficant gap between the decision trees and the way real-life decisions are made. This gap exists because our brains respond to sound, color, words or phrases and images which prime our later decisions. Even how or what is considered risky is subject to perception.

If risk management is susceptible to perception…

This may limit how useful game theory actually can be to identifying and managing risks. In a McKinsey and Company article, the writers noted that many managers are looking for a single or, at least, simplified answer to potential risks. The business environment is a highly dynamic place and expecting reasonable behavior and succinct solutions may be off base.

On the other hand, this same McKinsey and Company article proposes that game theory takes in various scenarios, factors and possibilities. This is actually multiple games. For those conducting the risk management, they might be looking a list of choices leading to choosing the “most robust.”

What do you think? Does game theory support better risk management or is it too academic to be useful? Join us this Friday, November 8, 2013 at 5pm GMT/12pm ET/9am PT to discuss risk managment and game theory.

How can underlying assumptions be made obvious during the decision-making process?

Are risks defined by some sort of objective understanding or are they influenced by geography and culture? Why/Why not?

What are the advantages of using game theory in risk management?

What are the disadvantages of using game theory in risk management?

What other decision making theories might be more useful to risk management?