• Risk
  • Economic Research

The Probability Specialist: Sam Savage

Professor Sam L. Savage of Stanford University, author of The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty, helped pioneer the field of probability management while working with Royal Dutch Shell. He discusses how we can use scenario planning and probabilistic modelling to help us deal with complex risks.

Sam Savage

Could you briefly summarise probability management?

In 2005, Royal Dutch Shell could easily simulate single projects, like oil exploration. However, aggregating those individual simulations together to account for the interrelated uncertainties of the entire portfolio was an issue. Probability management allows you to do that. This technique represents each uncertainty as an array of auditable, simulated outcomes and metadata called a stochastic information packet (SIP), which can be added to simulate the risk-return distribution of the portfolio.

Can you explain that in terms of financial markets?

Think of the efficient frontier in finance. You need a process of optimising the trade-off between risk and return, which can then be applied to individual circumstances. Any point along the efficient frontier depends on your corporate risk attitude, so you need to understand that in order to choose correctly. Risk is in the eye of the beholder.

What about pandemic risk?

Think of several efficient frontiers. Imagine trying to mitigate the risks: safety; liability; and cost. Every efficient frontier is at a different cost, with each curve representing the trade-off curve between residual safety risk and residual liability risk. You really have three stakeholders – safety advocates, liability advocates and financial advocates. They are negotiating.

If you don’t go through the process of optimising the trade-off between the risk and return, then you could wind up with a suboptimal outcome

At one end, there is no risk at all, but it will cost a lot of money. At the other end, the number of deaths will be overwhelming, but the cost would be minimal. There must be a sweet spot. However, if you don’t go through the process of optimising the trade-off between the risk and return, then you could wind up with a suboptimal outcome.

Why is it so hard for organisations to prepare for risks they should have seen coming, like the pandemic?

First of all, I am a free-market guy. Very closely related to the financial markets are the prediction markets. They got Trump wrong, they got Brexit wrong and they got COVID-19 wrong. So, we were blind-sided. And yet, you can be sure the market was picking up some signals as this crisis was unfolding.

For example, if China had been hoarding personal protective equipment before the pandemic really hit, then there would have been signals to reflect that. You can’t hoard something without changing the price of that, right? And you could have picked up on some of these signals. As an efficient market advocate, I think markets are pretty efficient, but they are not completely efficient. There are signals here and there, and we should be watching them very closely.

If there are so many signals, how do you know which ones are important?

Artificial intelligence and machine learning would be my first approach. We have a lot of data. The problem is that, in a lot of cases, they are highly non-linear. And that means they are subject to chaos. So how should you monitor the obvious signals? You are not trying to figure out what is going to happen in the long term – you want to figure out whether things are about to go chaotic. This is essentially the butterfly effect, where minute influences can have huge effects on non-linear systems.

Can financial markets exhibit chaotic behaviour?

They can, absolutely. Typically they don’t, but an example would be the sudden correlation of everything when markets all drop at once: that is a chaotic system. And even though you might not be able to predict it, you can do scenario analysis. You need to know what you would do if an unlikely scenario would happen. At Royal Dutch Shell, they didn’t think the Soviet Union would collapse before it happened but they knew what to do if it did happen. That is scenario analysis.

Cybersecurity attacks present another unpredictable risk. If you can’t predict it, how do you manage it?

This risk is different from all the rest. You cannot treat cybersecurity threats as you would a nuclear meltdown in a power generation plant. It frustrates me and other modellers when we see people modelling cybersecurity like the threat of a nuclear meltdown in a power generation plant. The nuclear reactor is not out to get you. If the core melts down, there is something wrong with the physics. In cybersecurity, you have an intelligent adversary. You simply cannot get through this without invoking game theory.

You mentioned game theory. Can you explain why gamers are generally better at managing risk?

The best risk modellers are gamers because they learned the game by playing the game, not by concentrating on writing down in advance what they were going to do. They didn’t sit there and read a book, and then decide how to do it. They learned to ride a bicycle by riding a bicycle. They didn’t waste time by writing a bicycle mission statement or making sure they have the right bicycle outfit. I often get this when people come to me for assistance: they just want to write about bicycles, they don’t necessarily want to ride a bicycle.

How would you model climate change risk?

With climate change models, I wouldn’t recommend using just one; there are many. They are huge and humongous, and almost collapsing under their own weight, but they contain a lot of valuable information – so long as you don’t use an average. Take economic modelling around the world due to sea level rise. What you can do is write out a SIP library, write it in the cloud in an open, standard way that allows everybody to have access for free.

This global SIP of sea level rise could be accessed by individual regions, which in turn would calculate their own SIPs of economic impact based on local knowledge of factors such as the hydrology, tide basin and storm surges. The resulting SIPs would be coherent in that they reflected the same sea level conditions on each trial and could be added together to estimate the global economic impact. The data and the technology are there, it is a matter of getting everyone on board.

Want more content like this?

Sign up to receive our AIQ thought leadership content.

Please enable javascript in your browser in order to see this content.

I acknowledge that I qualify as a professional client or institutional/qualified investor. By submitting these details, I confirm that I would like to receive thought leadership email updates from Aviva Investors, in addition to any other email subscription I may have with Aviva Investors. You can unsubscribe or tailor your email preferences at any time.

For more information, please visit our privacy notice.

Related views

Important information

THIS IS A MARKETING COMMUNICATION

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London, EC3M 4AE. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 138 Market Street, #05-01 CapitaGreen, Singapore 048946.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.