Indulge us in a quick risk-assessment quiz. You are faced with two corporate investment options with equal chances of success: Invest $20 million with an expected return of $30 over three years, or invest $40 million with an expected return of $100 million over five years (and an early dip in earnings). Which would you choose?
Despite its negligible additional risk and clearly superior net present value, the second option is rarely pursued. Instead, mid-level executives are far more likely to choose the smaller investment that protects short-term earnings (and bonuses), regardless of larger, longer-term gains, according to research conducted by McKinsey & Company.
In a study of 1,500 executives from 90 countries, McKinsey found that most participants rejected deals with a risk of failure larger than 20 percent, regardless of the investment's size or its potential to cause financial distress. In other words, the very people who make the most investment decisions "exhibit an unwarranted aversion to risk."
"In a single large company making hundreds of such decisions annually, the opportunity cost [of undue risk aversion] would be $2 billion if this were to happen even 20 times a year over five years," write Tim Koller, Dan Lovallo, and Zane Williams in the 2012 McKinsey report Overcoming a Bias Against Risk. "Variations of this scenario, played out in companies across the world, would result in underinvestment that would ultimately hurt corporate performance, shareholder returns, and the economy as a whole."
OK, so we understand why risk aversion matters. But why is it so prevalent? McKinsey points to two behavioral biases documented by Nobel Prize-winning economist Daniel Kahneman:
- Loss aversion: Generally, we fear losses more than we value equivalent gains.
- Narrow framing: Too often, we consider the success or failure of projects in isolation and fail to understand how each adds to the company's overall investment portfolio.
"To make matters worse, many companies also hold individuals responsible for the outcomes of single projects that have substantial uncertainty and fail to distinguish between 'controllable' and 'uncontrollable' events, leaving people accountable for outcomes they cannot influence," write Koller, Lovallo, and Williams. "As a result, many companies wind up with risk aversion at the corporate level that resembles that at the individual level--squandering the risk-bearing advantages of size and risk pooling that should be one of their greatest strategic advantages."
They recommend taking a company-wide approach to risk that comprises these five strategies:
1. Encourage managers and senior executives to explore innovative ideas beyond their comfort levels--ones that are risky but have high potential returns. "[You] could also require managers to submit each investment recommendation with a riskier version of the same project with more upside or an alternative one."
2. All project plans must include a range of outcomes "linked to real business drivers such as penetration rates, prices, and production costs." By forcing this analysis," the McKinsey reports says, "executives can ensure that the likelihood of a home run is factored into the analysis when the project is evaluated--and they are better able to thoughtfully reshape projects to capture the upside and avoid the downside."
3. Pin your discount rate not to a project's uncertainty or its range of possible outcomes, but rather to its relative size and contribution to the company's investment portfolio. "Adopt a rule that any investment amounting to less than 5 to 10 percent of the company's total investment budget must be made in a risk-neutral manner--with no adjustment to the discount rate."
4. Pool risks, pool rewards. "Wherever possible, managers should be evaluated based on the performance of a portfolio of outcomes, not punished for pursuing more risky individual projects."
5. Eliminate the role of luck. "Reward those who execute projects well, even if they fail due to anticipated factors outside their control, and . . . discipline those who manage projects poorly, even if they succeed due to luck."