Nobel prize winning economist Richard Thaler tells of a meeting he had with a CEO and the department managers of a large company in which they discussed risk and decision-making. Thaler asked each of the 25 managers to consider a risky investment opportunity for their department. The risky option had a 50% chance of losing half the capital under their control or conversely, a chance to double the amount of capital they controlled by 50%. Not one of the executives were willing to take the gamble. Thaler then turned to the CEO for feedback. Without hesitation, the CEO stated that he wished his executives would all have opted to try for the investment opportunities.
For the CEO this made perfect sense. He had a broad view of all the possibilities and risks. From that prospective, he realized that considering all the investments pooled together, the risk profile was much more attractive, and it was likely that the company would make a significant profit on the combination of transactions. While the CEO’s decision may seem obvious when we view it from his perspective, this simple example shows how organizations and their employees can become risk-averse. When businesses become too risk-averse in their decision-making, they can squander real opportunities for growth.
What we know about risk aversion can be attributed to a combination of two well-documented behavioral biases. The first is ‘loss aversion,’ a phenomenon where decision makers fear losses more than they enjoy equivalent gains. Some studies have shown that experiencing losses can even be twice as psychologically impactful as gains (as illustrated by the example above). The second bias is ‘narrow framing,’ where people tend to see a single investment or outcome —like flipping a coin only once— without viewing them in the context of the overall set of outcomes – like flipping 25 coins. Both of these biases are sourced from another Nobel laureate, Daniel Kahneman.
These biases are more than just academic theory. Recent studies from a Harvard Business Review article present a picture of business executives that are not “the risk-takers we hear so much of in industrial folklore. They portray decision-makers quite unwilling to take what, for the company, would seem to be rather attractive risks.” Business leaders often struggle to see individual investments or opportunities as just one of many opportunities they will have over the course of a month, a year or a career. That is why managers and executives have a tendency to favor projects that require smaller investments over those that require larger investments but have a more profitable outcome. So, how does a business reduce unnecessary risk aversion?
Push to develop proposals for high-risk-high-reward projects and explore innovative ideas beyond your comfort level. Compare your high-risk projects alongside proposals for safer projects with lower returns. Be sure to remember how loss aversion and narrow framing biases can influence you and your employees’ decision-making.
Evaluate performance based on portfolios of outcomes, not on single projects. No investment is perfect and even the best opportunities do not always pan out. When evaluating projects or your employees, base the grade on overall performance, rather than on individual project outcomes. By making risk less personal, you and your employees can evaluate future decisions with less bias.
Companies should understand whether a particular success or failure was controllable. Eliminate the role of luck – good or bad – in rewarding employees for a project. Remember that even well-executed projects will fail due to factors outside of your control. Outcomes can be influenced by competitors, regulators, natural disasters, commodity price spikes and the economic cycle. There is a strong element of chance in any investment and that needs to be taken into consideration.
Unless a failed investment would trigger financial distress or bankruptcy, sometimes the riskier but more profitable opportunity might be the right choice. Remember Thaler’s story and do not let profitable opportunities pass you by because of loss aversion. Don’t be afraid to see each investment as part of your business’s larger picture. It is almost never clear which investment is best, but by acknowledging our biases, business leaders can be more confident that they are not missing potentially valuable opportunities.
Looking forward to being a part of your success.
