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"Your Company Is Too Risk-Averse"


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https://hbr.org/amp/2020/03/your-company-is-too-risk-averse

 

Interesting piece.

 

presented the following scenario to 1,500 managers: You are considering a $100 million investment that has some chance of returning, in present value, $400 million over three years. It also has some chance of losing the entire investment in the first year. What is the highest chance of loss you would tolerate and still proceed with the investment?

 

A risk-neutral manager would be willing to accept a 75% chance of loss and a 25% chance of gain; one-quarter of $400 million is $100 million, which is the initial investment, so a 25% chance of gain creates a risk-neutral value of zero. Most of the surveyed managers, however, demonstrated extreme loss aversion. They were willing to accept only an 18% chance of loss, much lower than the risk-neutral answer of 75%. In fact, only 9% of them were willing to accept a 40% or greater chance of loss.

 

What’s more, the size of the investment made little difference to the degree of loss aversion. [...]

 

corporate incentives and control processes actively discourage managers from taking risks—a conclusion he felt was supported when managers he interviewed acknowledged that although their risk aversion was bad for their companies, it was good for their careers. [...]

 

For all but the largest investments, the consequences of project failure would be far higher for the managers than for the company as a whole.

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https://hbr.org/amp/2020/03/your-company-is-too-risk-averse

 

Interesting piece.

 

presented the following scenario to 1,500 managers: You are considering a $100 million investment that has some chance of returning, in present value, $400 million over three years. It also has some chance of losing the entire investment in the first year. What is the highest chance of loss you would tolerate and still proceed with the investment?

 

A risk-neutral manager would be willing to accept a 75% chance of loss and a 25% chance of gain; one-quarter of $400 million is $100 million, which is the initial investment, so a 25% chance of gain creates a risk-neutral value of zero. Most of the surveyed managers, however, demonstrated extreme loss aversion. They were willing to accept only an 18% chance of loss, much lower than the risk-neutral answer of 75%. In fact, only 9% of them were willing to accept a 40% or greater chance of loss.

 

What’s more, the size of the investment made little difference to the degree of loss aversion. [...]

 

corporate incentives and control processes actively discourage managers from taking risks—a conclusion he felt was supported when managers he interviewed acknowledged that although their risk aversion was bad for their companies, it was good for their careers. [...]

 

For all but the largest investments, the consequences of project failure would be far higher for the managers than for the company as a whole.

 

This is absolutely true.  It's so, so incredibly hard to create a culture where failure does not taint someone's career in a large company.  It's also incredibly hard to separate the process from the outcome (e.g., you don't want to create a culture where people are just making stupid bets in hopes of a big payoff).  Candidly I'm not sure there's a solve for this for organizations of any scale.  In many ways, this is just an extension of the issues that Clay Christensen talks about in Innovator's Dilemma. 

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A risk-neutral manager would be willing to accept a 75% chance of loss and a 25% chance of gain; one-quarter of $400 million is $100 million, which is the initial investment, so a 25% chance of gain creates a risk-neutral value of zero. Most of the surveyed managers, however, demonstrated extreme loss aversion. They were willing to accept only an 18% chance of loss, much lower than the risk-neutral answer of 75%. In fact, only 9% of them were willing to accept a 40% or greater chance of loss.

 

I'm curious if the researchers realized that this wasn't risk-neutral because of opportunity costs, or if the writer just wanted to make things "simple".  If you're in a company with a high ROE, then a 25% chance of a 300% return after 3 years (or 75% of nothing after one year) isn't even close to a break even proposition.

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I'm curious if the researchers realized that this wasn't risk-neutral because of opportunity costs, or if the writer just wanted to make things "simple".  If you're in a company with a high ROE, then a 25% chance of a 300% return after 3 years (or 75% of nothing after one year) isn't even close to a break even proposition.

 

I think you'd be surprised at how little VPs of companies understand even their own incentive compensation structure.  Like an option is basically a black box to them in terms of how it works.  So you're right logically, but I think the point that there's risk aversion generally within corporate America very much rings true. 

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I'm curious if the researchers realized that this wasn't risk-neutral because of opportunity costs, or if the writer just wanted to make things "simple".  If you're in a company with a high ROE, then a 25% chance of a 300% return after 3 years (or 75% of nothing after one year) isn't even close to a break even proposition.

 

I think you'd be surprised at how little VPs of companies understand even their own incentive compensation structure.  Like an option is basically a black box to them in terms of how it works.  So you're right logically, but I think the point that there's risk aversion generally within corporate America very much rings true.

 

Yes. I worked at a company where you could get your stock comp in your desired mix of RSUs and options. The options provided a multiplier with regards to share exposure. Almost everyone I spoke to who had chosen some percentage of options had never actually calculated or knew how to calculate what the underlying had to do to outperform the RSUs. Granted it was not a financial firm. In my experience, if you walk around a large cap company and start asking non-C suite leaders what the companies key metrics are (Revenue, Revenue mix, margins, ROE etc..), you will be shocked (at least I was). Again not a financial firm, I would expect more in one, but don't know. 

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