Brent Council’s Conrad Hall explores the similarities in risk management and decision making between professional gamblers and local government CFOs.
Before you leap up from your desk in a blind rage shouting “nothing whatsoever!”, there are a few points you might consider, especially as local authority finance is increasingly characterised by deliberate risk-taking for gain.
Of course, by “gamblers” I’m not referring to the very real and serious social issues caused by addictive, problem gambling.
For every Dostoyevsky, whose brilliance with a pen often compensated for his travails at the roulette wheel, there are hundreds of lives permanently blighted by the consequences of problem gambling; equally most would agree that an annual flutter on the Grand National, whilst still technically gambling, is just harmless fun.
By gambling I mean the deliberate placing of capital at risk for the prospect of gain, which if you think about it sounds a lot like pension fund and treasury management.
Of course you will be seeking to limit your risk rather more than a professional gambler might, of which more later. This will take me shortly to “risk appetite” (and if anyone can think of a less dreadful phrase to express the concept please let me know).
Beforehand, you might want to consider SJ Simon’s seminal 1930s book “Why you lose at Bridge”. To be fair, you may not play bridge (I haven’t for twenty years), but a surprising amount of it still stands by analogy as a good basis for decision making in public finance.
I particularly remember three things: Simon’s scalpel sharp portrayal of the “unlucky expert” (whose undoubted technical expertise is utterly ineffective as his partners can never understand and hence execute his plans); his brilliant way of explaining how people are “mathematically oblivious” in decision making (the idea that most decisions require only trivial mathematical skills but that people often simply don’t recognise when to apply them); and his assertion that professional bridge players, often gambling for high stakes, only ever asked themselves three key questions about any decision at the card table:
- How much do I stand to gain?
- What could I lose?
- What are my chances of success?
When these three questions can be answered with precision, as in pension fund and treasury management, then once you’ve established your risk appetite they will inform any decision you are faced with, and can even be used more widely.
Do you make these decisions explicitly in this framework? Or do you just have a pretty good feel, based on experience, that the proposed decision “looks good”?
Worse, do you rely on your “unlucky expert”, who has a much too complicated spreadsheet, and takes their analysis on faith even though no one else understands it or could execute it in the way intended.
Whichever of these three approaches you adopt, you need to set out your appetite for risk first. There’s a very simple exercise which I use in training courses to make the rather hackneyed phrase real to staff. Imagine a horse race, because simple gambling like this is easy for everyone to understand.
To keep it simpler still, suppose there are just three horses, with low, medium and high odds, say 3-1, 5-1 and 7-1. Which would you bet on?
Saying you’ll bet on 3-1 is analogous to expressing a risk appetite something like “I want to minimise the risk of losing my capital, and will accept the lowest return available in the market to achieve that primary objective”.
5-1 could be “I don’t mind some more risk for a better return, but not excessive risk” and 7-1 might be “I want to maximise my possible return and will accept a higher risk of losing capital as a result”.
It’s always surprising how few staff ask themselves my three questions, perhaps because they are mathematically oblivious, and answer that rather than bet on any one horse they will re-mortgage the Civic Centre for £30m, put £10m on each horse, and answer the three questions as follows:
- At least £10m
- Nothing
- Certain
Room 151 readers will of course have spotted the trick question and I’d be willing to place a (small, prudent and affordable) wager that the regulars in your local bookmaker would get this one right too.
Of course, you may argue with some force that no bookmaker would ever offer such odds. Perhaps, but without intending any political connotations whatsoever, remember that just after the nominations closed Jeremy Corbyn was between 100 and 200 to 1 with every major UK bookmaker to be the next leader of the Labour Party. He was one of four in the contest, which already suggests that they’d got question three wrong. And in the preceding six months anti-austerity parties like Syrizia and Podemos, which advanced somewhat comparable economic platforms, had won elections in Greece and Spain.
The odds came tumbling down quickly as polls showed that the bookmakers really had got question three wrong. Some professional gamblers had also already done the calculation that only occurred to me with the benefit of hindsight (answering 1. lots, 2. not much, and 3. quite good) and put large sums on Mr Corbyn, making the bookmakers rapidly revise their answer to question two as well.
Certainly you need to be clear about your risk appetite. As I wrote at the start, although it will be lower than a professional gambler’s, the difference may surprise you. It’s great in the movies when someone announces “all in” in a poker game, usually with some absurd bluff. In real life the professional relies more on finding a game with at least one weak player (so the answer to question three is: better than his) and on knowing that if they keep finding mis-priced markets, like 10-1 odds for a 9-1 shot, they’ll win, provided they can stay afloat during the inevitable bad run.
“Markets can remain irrational longer than you can stay solvent” as Keynes said, a risk to which all of our pension funds are exposed. I might add that because markets are also driven by sentiment, rumour and assumptions about political decisions this risk is actually greater than the equivalent (and purely mathematical) risk of a run of persistent bad luck faced by a professional card player.
If embracing commercial risk-taking is here for the long-term then you need to maximise your opportunities and manage your risk, and the clarity and simplicity of a professional gambler’s decision making framework has much, conceptually, to recommend it.
We’re not gamblers, but we should perhaps remember that some of the differences between us are less than we might like to think.
Conrad Hall is chief financial officer at the London Borough of Brent.
