Chertoff Addresses the Beta
When businesses consider investments in projects or acquisitions, they’ll often times use something called the capital asset pricing model, or CAPM. In that equation we quantify some ordinarily unquantifiable things. For example, risk. In the CAPM and other applications, risk is referred to as beta. This month, Secretary Chertoff delivered an address at the Wharton School of Business to explain his views on how the nation should deal with risk management and how his Department has tried to value the beta in our nation’s homeland security mission.
Chertoff explains his rule of thumb as follows: “I look at the issue of, you know, probability and consequence, I put a lot of weight on the consequence end of the equation.” In a nutshell: weight the consequences more than the likelihood of something bad happening.
This is an interesting choice, and a tough one for the head of DHS. The mindset Chertoff offered to the audience of business students and faculty was not the sort we are taught in M&A class or the kind you’ll find on Wall Street. If it was, firms that consider investing in a company would not value the assets, liabilities, and synergies; they’d first consider what the consequences would be if, say, the entire leadership of that target company turns out to be a bunch of frauds on the verge of indictment and what could limit the impact of such an outcome or limit the likelihood of it at all. It isn’t a smart on Wall Street and it could represent an imbalance when it comes to the homeland in general.
The Secretary explains that “managing risk is fundamentally looking ahead to the possibility of a disaster that is yet to happen and then to make cost-benefit driven plans to prevent disaster or to reduce our vulnerability to the disaster or mitigate the effects of the disaster that occurs.” Hard to argue with that. However, Don, a Wharton student in the audience asked the Secretary to clarify “how it’s possible to [defend the homeland] when the costs of remedying a risk are too great or the probability itself are too small and it’s necessary just to let it go.”
Secretary Chertoff offered “the one general principle” that he applies when considering risk management. “I put a lot of weight on consequences. [If the] consequence is catastrophic, even if it’s the low probability, is to me something that warrants a lot of effort to prevent and to prepare for. [If the consequence] is bad but not out of the ordinary is one where I might be more willing to be a little bit more modest in terms of preventive measures that I take…. So my big rule of thumb is when I look at the issue of, you know, probability and consequence, I put a lot of weight on the consequence end of the equation.”
Of course, this may not really be what happens in practice: In FY09 DHS received about $500 million to combat smuggled nuclear weapons (low likelihood/devastating consequence) and $1.3 billion to combat improvised explosive devices (high likelihood/less deadly consequence). So it appears that despite an advertised focus on consequences over likelihood, DHS continues to invest in combating those threats that are more likely over those that are more devastating.
