Risk Aversity – Issues and Answers in Leadership
In the past, I have mentioned risk aversity in my thoughts on innovation as a threat to an organization’s “cash cow.” This week, I want to look a little deeper into risk aversity.
Risk aversity is the innate reluctance to engage in what is perceived as a risky venture or to undertake a risky course of action. Behavioral research indicates that people tend to avoid a risk that does not offer a payoff that is at least twice the potential loss. Simplistically, this means that if I proposed the following bet, you would be strongly inclined to reject it.
- I flip an honest coin one time
- If the coins lands heads up, you lose $100
- If the coin lands tails up, you win $150
In fact, the research has shown that you would be strongly inclined to reject the bet if your single flip winning was anything less than $200 (and you might reject that). The pain of losing far outweighs the pleasure of winning.
If you don’t think that is true, ask yourself if you would bet $100 on a single flip of a coin – even odds, win or lose $100. I know I would not. I could buy my favorite latte at Starbucks for more than a month for that $100, so I would be risking a month’s enjoyment. I’m risk averse.
This comes into play in a very significant manner in business.
When a company is reaping the gains of a “cash cow,” any program that they initiate that puts that cash cow at risk would need (based on the research) to offer the opportunity to double to gains they are currently getting from the cash cow (because they would, by necessity, be putting their cash cow at risk of losing most or all of the cash cow revenue stream).
For example, the iPod/iPhone/iTunes eco-system was developed by Apple – a company with precisely zero cash-cow revenue from the music business. That eco-system was not developed by any company already in the music business. Those companies were cashing in on album sales – their cash cows were high-margin earnings for every CD burned. It appears never to even have occurred to them to create a new way to sell music – even though all the technology was mature and openly available. Apple’s innovative new music eco-system killed that cash cow by giving music fans the option of buying individual songs at little more than the per-song cost of an album. I’ll boldly assert that risk aversity was so strong that it prevented the old music industry from even thinking of a different way to sell music.
There is another aspect to consider. I just finished reading Richard Thaler’s new book, MisBehaving. In it, he briefly discusses a publishing company comprised of thirteen relatively independent units. The leader of each of those thirteen units was asked if they would pursue an attractive, but risky, new venture. Only three of the thirteen leaders said that they would. The remaining ten leaders would not because they were concerned that a failure of their risky venture would impact their individual incentive bonus. In parallel, the CEO of the entire company was asked how many of the thirteen risky ventures he would want to see pursued. He wanted all thirteen to be pursued. He was looking at the cumulative probability of success and failure across thirteen ventures and the results were extremely attractive while each unit leader was looking at a single success/failure. Risk aversity at the unit level killed ten initiatives that at the company level could have created major new revenue streams.
In parallel, the CEO of the entire company was asked how many of the thirteen risky ventures he would want to see pursued. He wanted all thirteen to be pursued.
What was the problem? A trick question to which I have not provided enough actual information for you to answer. That said, I think the answer is that the CEO had not done two things to address unit-level risk aversity:
- He had not created an incentive system that encouraged unit leaders to look beyond their unit
- He had not communicated his personal (or perhaps her personal – the book was gender neutral) risk strategy to his unit leaders
So, once again, the issue and the answer is leadership – in this instance, the leadership issue is how to address risk aversity. The leadership answer is to thoroughly think through your organizational strategy – with an understanding of the powerful impact of risk aversity – and to craft your strategy implementation to overcome the barrier to success that risk aversity poses. To paraphrase Kermit the Frog, “It ain’t easy being a leader.”
About Guy Higgins:
An engineer by education, a technologist by avocation and a problem-solving leader, Guy is widely recognized for his ability to quickly see to the crux of an issue and to focus on a solution. Guy has solved problems in stable operations, in times of crisis, and for the long term. “The primary focus has to be on a viable solution – before technology, or processes or tools are considered. It’s all about solving the problem – as quickly as possible, while keeping a long range perspective.”
Guy traffics in ideas and thinks that every valuable idea must fit into the real world – how the world is and how it works. A life-long learner, he reads voluminously and eclectically and continually updates his “mental model” of the world. His ability to understand the world today – and how it is evolving – enhances his ability to contribute to useful and executable solutions.
In today’s world, change is accelerating in numerous dimensions and companies recognize that they need expert help to deal with those changes. Guy’s forty years of experience have shown him that close collaboration between the problem-owning client and any consultant is vital to the successful solution of the problem. Accordingly, he works closely with clients to develop a shared understanding of their problem in all its crucial dimensions. He moves from that understanding to an executable solution that delivers results quickly without just “kicking the can down the road.” He helps companies solve problems so they “stay solved.”
Guy has led major acquisition programs for the US Navy, achieving an unsurpassed 100% success rate (five for five) in operational testing – on cost and on schedule. He has likewise led major captures and large functional organizations for industry. He has explored new markets and championed innovation – in technology and products, in organization and leadership, and in business models. Throughout his career, Guy has maintained a “customer-centric” approach – for Navy warfighters and for business customers.
Guy earned a Master of Science degree in engineering as a Guggenheim Fellow and is a graduate of the US Navy Test Pilot School.
Guy’s philosophy: Life is a basketball game, not a ballet – you need to be prepared and have a game plan, but don’t expect the game to follow a script. Business has to be played in real time as well. You can’t choreograph the future, but you have to plan for it while knowing that the details of the plan will change.