Balancing Risk and Reward
Businesses have to take risks. There is no such thing as a risk-free business.
Demand for a company’s goods or services might suddenly drop for a number of reasons beyond the control of the company. There could be disruptions in the supply chain. A technology might not work out, or an advertising campaign might backfire. A lot of things can go wrong.
So why take risks in the first place? The answer is simple: reward.
There would be no reason to take risks if there was no potential reward associated with it.
Say somebody offered you the following gamble: you can flip a coin and if it lands on heads, you get $1000, and if it lands on tails, you lose $500. Or you can get $1000 with certainty.
Of course you would take the second option! There would not be any incentive to take the risk of flipping the coin.
Now of course that isn’t a realistic example. But what if the gamble stayed the same, but instead you could get $250 for certain? What would you take? There is no right or wrong answer here, as it depends on each individual’s particular risk tolerance. But the underlying principle is the same: as risk increases, people expect to be compensated to a greater extent for taking a greater risk. And similarly, they will be willing to pay more to avoid taking a greater risk, in order to attain some certainty.
When does risk increase? Either 1) when likelihood of a bad outcome increases, 2) the consequences of a bad outcome increase, or 3) when both the likelihood and negative consequences increase.
Risk and reward lies at the heart of Benjamin Franklin’s famous “moral or prudential algebra” - i.e., listing out the pros and cons of a decision (1). Roughly speaking, pros and rewards, and cons are risks. Franklin describes a way of accounting for the risks and rewards, and for determining which side of the scale is heavier. If the risks outweigh the rewards, then it is prudent not to move forward. If the rewards outweigh the risks, then it makes sense to follow through with the decision.
While this is admittedly a rough rule of thumb, the logic underpinning it makes sense: when faced with a tough decision, take time to think through the risks and the benefits. Thoughtfully articulating both the upsides and downsides facilitates better decision making. It also points to another truth – that there is no such thing as a free lunch. With greater rewards come greater risks.
The trick isn’t necessarily to always avoid risky decisions, but rather to make smart, strategic decisions. The key is not to take a purely defensive posture to risks, but rather to recognize that the other side of the risk coin is opportunity. Disruptive innovations can be viewed as risks to the status quo, or can be seen as an opportunity to create value (2).
That involves thinking strategically about balancing risks and rewards - the likelihoods of different events, the associated payoffs, your own risk tolerance, and the overall alignment of the risky decision with the organization’s goals and strategy. A good decision for one organization may not make sense for another.
At Collier Research Systems, we can help your company sort through the pros and cons, and guide you toward a course of action that is aligned with your particular goals and strategy. To learn more about how to balance your risks and rewards, visit: www.collierresearchsystems.com.
(1) Benjamin Franklin, Letter to Joseph Priestley, 1772. http://www.decisionsciencenews.com/2012/08/18/benjamin-franklins-rule-for-decision-making/
(2) Balaji, S. 2017. The Strategic Value of Risk Taking. Risk Management Magazine. http://www.rmmagazine.com/2017/09/25/the-strategic-value-of-risk-taking/