It seems to be a law of nature, inflexible and inexorable, that those who will not risk cannot win.

-John Paul Jones

In recent episodes, specifically Episode 6: The Peter Principle and Episode 8: Bureaucracy, we spoke to the idea of Risk and risk-averse mindsets and behaviors.

So, I decided that it is time to dive into the topics of Risk and Risk-aversity, its effects, both positive and negative, how its presence can be recognized, and most importantly how to keep both in check and at levels that are positive to our organizations.

I have decided to break our conversation on Risk into three parts. The following episodes will publish as Episodes 10 and 11.

Definitions

Per the Cambridge Dictionary, Our two keywords for this topic are defined as such:

• By itself, Risk is defined as willingness- to do something although there is a chance of a bad result:

• Risk-averse on the other hand is defined as being- unwilling to take risks or wanting to avoid risks as much as possible:

• averse (adj.)
  • mid-15c., “turned away in mind or feeling, disliking, unwilling,” from Old French avers “hostile, antagonistic” and directly from Latin aversus “turned away, turned back,” past participle of avertere “to turn away,” from ab “off, away from” (see ab-) + vertere “to turn” (see versus). Originally and usually in English in the mental sense, while averted is used in a physical sense.
  • Averse applies to feeling, adverse to action: as, I was very averse to his going: an adverse vote: adverse fortune. [Century Dictionary, 1906]

Acceptance of Risk Behavior

 

Tory Higgins of Columbia University spent 20 researching risk-averse behaviors. He calls those who show an acceptance of risk; promotion focused.

Those who fit this title, in Higgins’s findings, see goals, whether specific to a task’s end, those of an organization, or one’s career, as opportunities to make progress. To end up in a better standing or position. These folks are promotion (not always in the title-change sense of the word) focused and not particularly averse to risky decisions and choices when they hold a possibility of gains.

Remember this, “promotions” are not specific to one’s title and pay. They are looking to promote or push forward, the organization too.

As a conversation starter, here’s the author of The Checklist Manifesto, surgeon Atul Gawande on appendicitis surgery from his October 3, 2011, New Yorker Article, Personal Best,

Reading now:

    Say you’ve got a patient who needs surgery for appendicitis. These days, surgeons will typically do a laparoscopic appendectomy. You slide a small camera—a laparoscope—into the abdomen through a quarter-inch incision near the belly button, insert a long grasper through an incision beneath the waistline, and push a device for stapling and cutting through an incision in the left lower abdomen. Use the grasper to pick up the finger-size appendix, fire the stapler across its base and across the vessels feeding it, drop the severed organ into a plastic bag, and pull it out. Close up, and you’re done. That’s how you like it to go, anyway. But often it doesn’t.

    Even before you start, you need to make some judgments. Unusual anatomy, severe obesity, or internal scars from previous abdominal surgery could make it difficult to get the camera in safely; you don’t want to poke it into a loop of intestine. You have to decide which camera-insertion method to use—there’s a range of options—or whether to abandon the high-tech approach and do the operation the traditional way, with a wide-open incision that lets you see everything directly. If you do get your camera and instruments inside, you may have trouble grasping the appendix. Infection turns it into a fat, bloody, inflamed worm that sticks to everything around it—bowel, blood vessels, an ovary, the pelvic sidewall—and to free it you have to choose from a variety of tools and techniques. You can use a long cotton-tipped instrument to try to push the surrounding attachments away. You can use electrocautery, a hook, a pair of scissors, a sharp-tip dissector, a blunt-tip dissector, a right-angle dissector, or a suction device. You can adjust the operating table so that the patient’s head is down and his feet are up, allowing gravity to pull the viscera in the right direction. Or you can just grab whatever part of the appendix is visible and pull really hard.

    Once you have the little organ in view, you may find that appendicitis was the wrong diagnosis. It might be a tumor of the appendix, Crohn’s disease, or an ovarian condition that happened to have inflamed the nearby appendix. Then you’d have to decide whether you need additional equipment or personnel—maybe it’s time to enlist another surgeon.

    Over time, you learn how to head off problems, and, when you can’t, you arrive at solutions with less fumbling and more assurance. After eight years, I’ve performed more than two thousand operations. Three-quarters have involved my specialty, endocrine surgery—surgery for endocrine organs such as the thyroid, the parathyroid, and the adrenal glands. The rest have involved everything from simple biopsies to colon cancer. For my specialized cases, I’ve come to know most of the serious difficulties that could arise, and have worked out solutions. For the others, I’ve gained confidence in my ability to handle a wide range of situations, and to improvise when necessary.

Is Mr. Gawande showing Risk-acceptance or risk-aversion?

 

Risk-averse Behaviors

Tory Higgins, it might be more accurate to say that some of us are particularly risk-averse, not because we are neurotic, paranoid, or even lacking in self-confidence, but because we tend to see our goals as opportunities to maintain the status quo and keep things running smoothly. Higgins calls this a prevention focus, associated with a robust aversion to being wide-eyed and optimistic, making mistakes, and taking chances.

This tendency of managers towards too much risk aversion is the subject of this article from McKinsey & Company.  

The authors, Koller, Lovallo, and Williams, demonstrate the potential significance of this bias toward avoiding risk.  Via their research in the area of behavioral biases, they have observed that:

1. Managers tend to favor projects that require smaller investments over those that require larger investments, even when both alternatives are projected to have positive outcomes relative to the size of the investment.
2. Executives tend to be as risk-averse about small investments as they are about large investments.

The authors note that when the tendency to avoid risk is applied to each of the numerous business decisions that must be made each year, it can compound to result in an organization that is operating well below its overall risk appetite.  This could easily make a business less competitive than it should be.  The authors go on to explain the root causes of risk-avoidance behavior among managers, and they also provide suggestions that may help organizations to curb unnecessary risk aversion.

Root Causes of Risk Aversion

The article points to the following behavioral biases as contributing factors to risk-averse behavior:

1. People naturally steer clear of potential losses, even when the projected benefits of a decision equal, or even exceed, the potential for loss.
2. Managers tend to consider each business decision (and set of risks) on its own, rather than considering the successes and failures of all the decisions they must make over a period of time (i.e. a large number of projects may likely net out favorably, with some failures and some successes).

The authors point out that companies make these behavioral tendencies more pronounced by routinely rewarding or punishing managers based on the outcomes of individual projects, rather than on each manager’s overall track record.

h3. *Suggestions for Curtailing Risk Aversion*

In order for ERM to be truly successful, the risk management process must be supported from the top and cultivated throughout the organization and its culture.  In accordance with this sentiment, the article authors propose a “company-wide” approach to reducing unnecessary risk aversion.  Several features of this approach are:

1. Push, or even require, managers to develop proposals for high-risk, high-reward projects; consider those proposals alongside proposals for safer projects with lower returns.
2. Grade managers on the basis of overall performance, rather than on the basis of individual project outcomes.

h3. *Take-away*

This article from McKinsey & Company is certainly not advocating heedless risk-taking; rather, the article helps to expose a behavioral tendency among members of a management team that can undercut a company’s ERM process.  By eliminating an overabundance of risk aversion, organizations can ensure that they are taking an appropriate level of risk.

The idea of Loss Aversion crosses over to Risk-averse behaviors.

Daniel Kahneman in his book, Thinking, Fast and Slow spend a nontrivial number of pages on the theories of loss aversion.

Josh Kaufman, it is an amazing 2010 book, The Personal MBA: Master the Art of Business

Describes Loss Aversion as the tendency for people to respond twice as strongly to potential loss as they do to the opportunity of an equivalent gain.

I particularly like Kaufman’s definition/description of Loss Aversion.

I will read it to you now:

Loss Aversion explains why uncertainty appears risky, and why perceived threats usually take psychological priority over potential opportunities.

Recently, my wife Kelsey decided to withdraw some funds from an investment account. When the brokerage deposited the money into her bank account, they deposited an additional $10,000 by mistake.

Rationally, it shouldn’t have been a big deal — it was a simple mistake that was easily corrected. Emotionally, however, Kelsey felt like she was “losing” the extra money, even though it wasn’t really hers at all.

Loss Aversion is the idea that people hate to lose things more than they like to gain them. There are very few relationships that psychology is able to quantify, but this is one of them: people respond twice as strongly to potential loss as they do to the opportunity of an equivalent gain. If you look at your investment portfolio and notice that it’s increased by 100%, you’ll probably feel pretty good. If you notice that your portfolio went down 100%, you’ll feel horrible.

Loss Aversion explains why threats typically take precedence over opportunities when it comes to Motivation. The threat of loss used to require immediate attention, because losses were extremely costly — even life-threatening. Losing a loved one to a predator, sickness, exposure, or starvation is universally a horrible experience, so we’re built to do everything in our power to prevent that from happening.

The potential losses we typically face now are rarely as serious, but our minds still give them automatic priority.

Loss Aversion also explains why Uncertainty appears risky. Depending on the study you look at, anywhere between 80-90% of adults think it would be great to own their own business and work for themselves. If that’s true, why don’t more people start businesses? Loss Aversion: the threat of losing your job commands more attention than the opportunity to create a new self-sustaining business. The thought of starting a business, on the other hand, involves the specter of potential loss, which prevents people from getting started in the first place.

Loss Aversion is particularly pronounced in recessions and depressions. Losing a job, a home, or a significant percentage of your retirement fund isn’t life-threatening, but it feels horrible all the same. As a result, people tend to become more conservative, avoiding risks that could make things worse. Unfortunately, some of those risks—like starting a new business—may actually present a major opportunity to make things better.

The best way to overcome Loss Aversion is to Reinterpret the risk of loss as “no big deal.” Casinos are in the business of overcoming loss aversion every single day—in a sense, the ostentatious buildings on the Las Vegas Strip are enormous monuments to human stupidity. If Loss Aversion is such a big deal, how do casinos encourage people to play games in which they’re mathematically certain to lose money?

Casinos win by abstracting the loss. Instead of having players gamble with currency, which is perceived as valuable, the casino converts currency into chips or debit cards, which don’t feel as valuable. As the player loses this “fake” money over time, the casino will provide “rewards” like free drinks, T-shirts, free stays in the hotel, or other benefits to alleviate the sense of loss. As a result, losing becomes “no big deal,” so players continue to play—and continue to lose money night after night.

Loss Aversion is why Risk Reversal is so important if you’re presenting an offer to a potential customer. People hate to lose, which makes them feel stupid and taken advantage of. As a result, they’ll go to great lengths to ensure they don’t lose, and the best way to ensure that they don’t make a stupid decision is to not buy your offer in the first place. If you’re in the business of making sales, that’s a big problem.

Eliminate this perception of risk by offering a money-back guarantee or similar risk-reversal offer, and people will feel the decision is less risky, resulting in more sales.

I am going to close with a blog post by Paul Graham (co-founder of Y Combinator) from January 2017 titled: The Risk of Discovery

I will read it now.
Because biographies of famous scientists tend to edit out their mistakes, we underestimate the degree of risk they were willing to take. And because anything a famous scientist did that wasn’t a mistake has probably now become the conventional wisdom, those choices don’t seem risky either.

Biographies of Newton, for example, understandably focus more on physics than alchemy or theology. The impression we get is that his unerring judgment led him straight to truths no one else had noticed. How to explain all the time he spent on alchemy and theology? Well, smart people are often kind of crazy.

But maybe there is a simpler explanation. Maybe the smartness and the craziness were not as separate as we think. Physics seems to us a promising thing to work on, and alchemy and theology obvious wastes of time. But that’s because we know how things turned out. In Newton’s day the three problems seemed roughly equally promising. No one knew yet what the payoff would be for inventing what we now call physics; if they had, more people would have been working on it. And alchemy and theology were still then in the category Marc Andreessen would describe as “huge, if true.”

Newton made three bets. One of them worked. But they were all risky.

I think we have discussed the basic points of Risk.  Join us next week as we will be returning to the ideas of Risk in Part 2. and diving deeper into these ideas and observations and how Risk behaviors are pertinent within businesses and organizations today.

Links to resources are in the show notes and on the “Links Page” on my website, Eddiekillian.com

Join me next Tuesday as we continue to travel the path of what is difficult, perilous, and uncertain as we explore introducing A New Order of Things.

I am your host, Eddie Killian. And this concludes Episode nine.