Risk of extreme events and the fallacy of the expected value

Most, if actually not all, managerial decisions are characterized by (a) elements of risk, uncertainty, and inadequate information and (b) multiple, noncommensurate, completing, and often conflicting objectives. To manage risk, professionals must assess it. This is usually done by a process of its identification, quantification, and evaluation. Thus, the assessment and management of risk is essentially a synthesis and amalgamation of the empirical and the normative, the quantitative and the qualitative, and the objective and the subjective. This paper will address the process of risk assessment and management, focusing on the trade-offs that must be made among all costs, benefits, and risks. In the process of risk assessment, however, extreme and catastrophic events are often underestimated and commensurated with other less consequential events. Managers and decisionÂmakers are often most concerned with the risk associated with a specific case under consideration, and not with the likelihood of the average outcomes that may result from various risk situations. In this sense, the expected value of risk, which has until recently dominated more risk analysis in the field, is not only inadequate, but can lead to fallacious results and interpretations. A modification of this approach through the use of conditional expectation will be shown to better capture the risk of extreme and catastrophic events. This paper will focus on the importance of addressing extreme and catastrophic events explicitly and within the overall risk-based decisionmaking process, where trade-offs among costs and risks can be generated and evaluated.