GET RISKYFight biases to increase top line growth
Risk Bias McKinsey Quarterly Idea: it’s important for organizations to have a thoughtful stance on how to evaluate and judge risk in project approval process.
A Scenario With Two Choices You’re a sr. exec at a high-tech firm that needs to meet your earnings and has a project with two financing options: 1. Up front $20M with an expected return of $30M over three years 2. Up front $40M with an expected return of $100 million over five years (and a bigger dip in earnings in the early years) Both plans have same likelihood of project failure. Which do you choose?
This should be simple, right? Finance textbooks discuss using IRR, NPV, MIRR and other tools to determine capital provisioning for projects Debt increases risk of financial distress – and we know managers often focus on short-term results Therefore, managers may avoid risky projects even if they have positive NPVs. Textbooks would say to choose option #2 But…most executives choose #1. If you did that, you would lose out on $20M Not a lot, but it happens many times per year $2B if you assume 20x/yr over 5 yrs
Behavioral (Psych) Biases The problem is that our biases can lead us to make irrational decisions Overconfidence vs Risk Aversion CEOs forced to make decisions on multi-million dollar investments are typically risk averse Mid-level execs are typically risk neutral; they usually make many decisions on smaller investments and SHOULD be more risk-tolerant The problem: too many leaders follow safe, straightforward paths with slow growth rates & lower investments
A Test What: McKinsey decided to test mid-level execs capacity for risk Who: 1500 execs from 90 countries Result: “They demonstrated extreme levels of risk aversion regardless the size of the investment, even when the expected value of a proposed project was strongly positive”
Biases to be aware of Loss Aversion: people fear losses more than they value equivalent gains Inother words, I’m not going into a bet if I can lose as much as I gain. Narrow Framing: weighing risks as if there were only one outcome (don’t flip a coin once)
Loss Aversion Example You choose: Up-frontinvestment = $50M With two potential outcomes: 50% chance for PV = $100M 50% chance for PV = $0 So, should you do it? Should you go for the quick (safe) win as a mid-level exec?
What Happened Managers needed PV = $170M to do the project (70% risk premium) But, if you told them, you would pool the project with others, managers only needed a 2-3% risk premium This makes sense, because in sum, you should expect to have a positive NPV – the risk becomes much smaller with many projects
Five Lessons Don’t just consider projects in isolation Adjust reward systems to match portfolio of project outcomes Request riskier projects Scenario analysis: consider upside/downside Flops / home runs --- what have we seen before? Reward skill not luck Ensure you know what’s controllable vs. uncontrollable