88th minute of a soccer match. One of the teams is down by a goal and desperately tries to score. Defensive is not part of their repertoire anymore, let alone any tactical boundaries. It’s forward everybody, make it or break it. What a fun to watch, how entertaining!
The final seconds of a football match. The trailing team in possession 40 yards from the end zone. Quarter back in shotgun position, the offensive line putting in all power they have left to win him some time, three seconds later the “hail mary” pass is on its way to the end zone. It feels like the ball is in the air for ages, the tension has reached the climax.
Why are teams waiting until the very last seconds before they take more risk? Why aren’t soccer teams trying to score goals at any expense from the first minute on? Why don’t football teams go for a hail mary pass in every 3rd down and long situation? Because it doesn’t feel like being necessary!
But is it really about being necessary?
I was watching a presentation a couple of days ago in which the presenter talked about the unstable economic environment of these days and that good management should focus on trying to minimize risk. Sounds reasonable? Well, consider this: A factor often not explored extensively is the fact that risk usually comes with an opportunity – it’s the other side of the coin. Yet, we generally try to reduce risk instead of actively managing the return from the risk/opportunity trade off.
Let me explain this in more detail: There are three pathways for the exploration of the trade off: Where do we actively want to take risks to gain access to the opportunity potential? In which cases is the opportunity so limited that risk should be avoided? And: What is my/our risk taking preference?
1) Where do we actively want to take risks to gain access to the opportunity potential?
I wrote about risk taking a couple of times before. The problem is that the potential opportunity in many cases cannot be measured or specified. Yet, “believe in it” is something that many don’t feel comfortable with as a guiding line for conducting business (wrongly, if you ask me). One of the risks most commonly denied to be taken is the risk of trying new things, the risk of going into a direction different from what has been done before (for more on this topic, see my post “The Ultimate Competition: Play“). The point is that by now everybody should have learned that if you don’t differentiate from others you will fail to be successful on the market and if you aren’t constantly looking for ways to improve what you are doing, someone else will take you position soon.
So looking at the trade off, there is a huge opportunity, but the risk of taking it is actually rather small. It’s just the fact that trying new things requires organizations or deciders to move out of the comfort zone. And just like a hail mary pass in the 3rd down and long situation in the middle of the game, it doesn’t feel like being necessary.
What feels like risky does not necessarily have to be risky, too.
2) In which cases is the opportunity so limited that risk should be avoided?
There’s also the opposite case. Risks that are not paid for by an opportunity. Risks that we take without thinking about it, sometimes even because we don’t realize anymore that there is a risk. Take the automotive industry as an example. Lean production and just-in-time logistics processes are the mode of working in the entire industry. Practically nowhere in the entire supply chain, significant stocks are built up. It’s common practice and yes, in most cases it makes sense because it saves spending capital cost and enhances the flexibility. But there may be other cases. Cases nobody considers to tackle in a different way.
Is there something like a “risk bottleneck”? Are there stages in the chain, where the risk of a delivery disruption could be lowered significantly without losing too much, just by growing the stocks in that particular process step? These risk bottlenecks (does this term actually exist or was I the first to make it up in this context?) give a very limited opportunity, in this case smaller inventories, but a high risk, here a disruption in the supply chain.
We analyze our commercial processes thoroughly, we know what our profit drivers and value drivers are. But who knows what our “risk drivers” are?
3) What is my/our risk taking preference?
In investment theory, the terms of risk averse, risk neutral and risk seeking investors has been coined. A risk averse investor would rather accept a safe payoff which is below the mathematical return (average payoff) of an investment just to avoid having to take the risk. A risk neutral is indifferent, while a risk loving investor likes to take the risk even if the average payoff is below the safe payoff, just to be able to take the risk (some call this type a “gambler”).
In most organizations, risk averse behavior is incentivized. However, economically a risk neutral behavior is the most promising on the long run (as in any model, limitations apply). This difference is what the business model of insurance companies is based on.
When you deal with others it is important to know what their, but also what your preference towards risk is.
Now if we bring together these three points, the insurance company analogy becomes interesting again. As risk averse behavior is incentivized, we try to avoid risk. We try to give risk a rather general price tag, just like insurance companies do (e.g. in %). Risk is seen as purely negative. We don’t even consider the hail mary pass.
That’s not the best approach. I hope I was able to demonstrate that looking in detail at the risk/opportunity trade off instead of generally avoiding risk is the economically favorable path, even though it may seem unintuitive.
How it can be done? Well, let’s look at the 3rd and long example again. Your team has the ball on the midfield line. A field goal is not an option, so if the first down will not be reached the team would go for a punt.
How likely is it that you will get the first down? You can get an idea from experience, looking at how you and your opponents usually play. Maybe 30%? 50%? 70%? How much gain would a punt probably give you? Maybe 30 yards? 40 years? How far can your quarterback throw? Maybe 40 yards? Maybe 50 yards?
If you take all these factors into account, you can come up with a model for the risk/opportunity trade off. Maybe the return you expect from playing a standard play in the 3rd down on midfield line is 1.5 points and if you don’t succeed, your opponents will get the ball on their own 15 yard line. The hail mary may be at 1.7 points and if you don’t succeed, your opponents will get the ball on their own 25 yard line. See, now there’s a case. It’s not a feeling anymore, and it’s not purely trying to avoid risk.
Risk is not bad. Only risk without a good opportunity in return is.