Adversity – Lessons of a Tulip

As global markets attempt to recover from seven years of economic and financial crisis, new threats appear to grow at increasing rates of frequency.   The symptoms of economic risk-taking have long been evident; we’ve witnessed the results of financial accounting scandals in the early 2000’s and the excessive debt and leverage in more recent years.  In most cases, these risks have been the manifestation of our own making; however, Mother Nature has added to the cacophony of threats organizations and its people must deal with each year.  The importance of managing risk and developing contingency plans has never been more important.

The damage of excessive risk taking has been commensurate with the rise in the concentration of wealth, higher unemployment, increased competition and more regulatory rule-making.  The world appears increasingly complex and the need to manage this complexity has made the role of risk managers increasingly complicated.  Or has it?

Adversity is not a new phenomenon, nor are the risks we face today new.  History has shown that financial crisis is a recurring theme in human history and the patterns of excess are more common than they first appear.  The most well-documented and earliest financial crisis started with the Dutch Tulip Bubble in 1624.  The Dutch were torn, as we are today, between living beyond their means and missing out on a long-shot road to riches.

In the early 17^th century, Holland was the hub of financial commerce through its East Indies trading routes and excessive profits derived from shipping goods.  Having secured its independence from Spain, Holland diverted its resources to building wealth, allowing shipping merchants to build grand estates and elaborate gardens as a testament to their new status.  Much like the dot-com billionaires and millionaires have done, Holland’s wealthiest built their dreams on the tulip through sheer speculation.

One tulip bulb was said to have sold for 3,000 guilders, equivalent to the annual income of a wealthy merchant’s salary and twice the going price for a newly painted Rembrandt masterpiece.  Prices for tulips, which rose steadily through the 1630’s, were driven higher through the formation of a formal futures trading market with speculators and buyers seeking instant wealth — much like private equity and hedge funds today — with too few assuming the market could collapse.

Eventually, the tulip market crashed like all financial bubbles, but not before reaching ever higher price levels and speculation of even greater wealth.  Professional traders attempted to maintain prices at previously inflated levels, but the speculative bubble was complete, and tulips that had recently sold for a record price of 5,200 guilders sold for one one-hundredth of that price only weeks later after the crash.  The financial collapse and debts owed by merchants and traders was massive and were settled for pennies on the dollar.

The Tulip Bubble financial crisis is less about the tulip or any other commodity whose value is the subject of speculation.  The lesson is that risk management fails to account for human emotion and passion taking over, when rational behavior is thrown to the wind.  The lesson, while well-learned, can’t be avoided because the fear of missing out on wealth or some other coveted “thing” appears greater than the risk taken to acquire wealth.  It is as basic as the reason we eat dessert after overeating instead of exercising or why teen driver accident rates increase substantially with the number of friends in the car.  Dan Ariely taught us this in his seminal book, “Predictably Irrational,” yet risk professionals and regulators alike fail to effectively deal with this “heat of passion” as a risk factor.

What can be done?  Risk professionals must be attuned to the warming of these speculative passions as the root of risk-taking.  Risk-taking is not the problem in itself; operating principles change as the market chases profitability, presenting the risk professional with the opportunity to discuss how the organization would handle a sudden change in market conditions.  A balance must be struck between sounding like Chicken Little crying “the sky is falling” and going along with the heat of passion simply because of short-term financial benefits.

All risks are relative, and each action taken should be commensurate with the level of risks assumed by each organization; however, awareness of this basic instinct may be all that is needed to avoid being the last person holding the most expensive “tulip” on earth.  Risk management is less about avoiding risk and more about understanding how we create our own risk and anticipating the adversity of battling our own human nature.