Managing Catastrophic Risk: Why it’s Critical and How to Do It!
Catastrophic Events and Consequences for Value
Managing catastrophic risk exposure is much more difficult than managing continuous risk exposure, explains Aswath Damodaran. Here’s how to incorporate the risk from catastrophes into valuation models.
The airwaves have been inundated with news about natural disasters in Japan and their aftermath. Without minimizing the human impact—the thousands who have lost their lives and belongings—and the dangers of a nuclear meltdown, I want to focus on the impact of catastrophes, natural or man-made, on markets and asset values. While each disaster is different, here are some common themes that emerge after the disaster:
a. Our definition of “long time periods” is woefully inadequate: After the quake, which measured 8.9 on the Richter scale and ranked as one of the five strongest in recorded history, it was noted that nothing of this magnitude had been seen in Japan over the last 300 years. Since much of the regulation (of construction and nuclear power plants) had been structured based upon past history, they proved inadequate for the quake. As I look at how much of what we do in corporate finance and valuation is based upon time periods of 80-100 years (if we are lucky) and 10-20 years (if we are not), I wonder how much we are missing as a consequence of our dependence on the past.
b. Experts are always “surprised” and are exceptionally good at ex-post rationalization: I am not that knowledgeable about earthquakes, but as I watched earthquake experts on the news in the days following the quake, I was struck by how much they reminded me of financial experts after the banking crisis in 2008 in their messages. First, for the most part, they admitted to be surprised by both the magnitude and the location of the quake (just as banking experts were surprised by the magnitude of and players in the sub-prime crisis). Second, they waxed eloquent about how uncertain they were about long term consequences…which leaves me wondering why we call them experts in the first place.
c. The doomsayers will have their day in the sun: In the aftermath of every crisis, there will be people who emerge from the woodwork to say “I told you so.” They will be feted as celebrities and treated as oracles, at least for a while. My response is less positive. After all, I have walked by the crazy preacher in Times Square almost every weekday, for close to 25 years, and he has warned me every single time that I have passed him that the end of the world was coming… He did sound prescient on September 12, 2001, but he was bound to, sooner or later. That is the reaction I have to those who preach doom and gloom all the time. They will be right at times but I will not attribute that success to wisdom but to accident….
d. Managing catastrophic risk exposure is much more difficult than managing continuous risk exposure: As companies and investors with Japanese risk exposure struggled with the aftermath of the disaster, I was reminded again of how much more difficult it is to manage and deal with discontinuous risk than continuous risk, especially if that risk occurs infrequently and has large economic consequences. In fact, this is the reason that I argued that companies that think that operating in authoritarian, stable regimes is less risky than operating in democratic chaos are mistaken. It is also the reason why managing exchange rate risk in a floating rate currency is much easier than managing that risk in a fixed rate currency.
