The HeadScratcher Post Archive
April 2009
The Thinking behind Risk
   
        April 2009  The Headscratcher Post © Headscratchers LLC   Edition 48
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The Thinking behind Risk

When we make decisions,
we weigh "risks" and "rewards". What do we mean by Risk?  Mathematically, Risk is the probability of an uncertain downside outcome multiplied by the cost of that outcome.

Translate that to Business:  How does one determine Risk and use it to make decisions?   There are two substantial components to Risk.  One relates to the study of the psychology of risk, which can, for example, pertain to the hormones produced during activities such as mountain climbing, and gambling, i.e. “the thrill”. The second is the Thinking behind risk.

Today, we’re going to discuss the “Thinking behind Risk”, and leave the psychology of risk for another time.  The components in the “Thinking behind risk” include:

   - DownSide Outcome
   - Uncertainty
   - Ignoring the Statistical Downside
   - Controllability
   - Ability to absorb Downside
   - Necessity of the Upside

Downside Outcome This is the negative result that might occur with any decision.   If you commit to a schedule for a deliverable, a downside outcome would occur if you missed the schedule, possibly resulting in a lower performance rating, re-assignment to another job, or perhaps even being fired.  There can be multiple downsides for every initiative, some more costly than others.

Uncertainty - This is the statistical uncertainty of an outcome.   If you flip two coins, statistically, there is a 25% chance that both will be heads, a 25% chance that both will be tails and a 50% chance that one will be heads and the other tails.  Business isn’t that easy!  For example: There isn’t a simple way to calculate the probability of missing a schedule.  In business, you make assumptions on the “chances” or uncertainty of a particular outcome.   Since your assumptions might be different than others, the uncertainty assigned will vary as well.  This results in different “confidence” levels.

Ignoring Statistical Downside When the uncertainty or probability of a downside is very low, you tend to just ignore the downside.  For example; driving a car.  There is a downside probability that you may have a serious accident, yet you almost always discount and ignore this, as the probability is fairly low.  Small probability downsides in business also tend to be ignored … then everyone is “shocked” if and when something goes wrong.  Does this sound familiar … “What do you mean we are behind schedule?”

Controllability this is related to how much control you think you have over an outcome, i.e. beating the statistics.  For example, if you think you’re a safe driver, then you’ll tend to discount the statistics on car accidents.  The more control you think you have, the lower the downside probability you will typically assign (the higher your confidence).

Ability to absorb the downside If you had $1,000,000 and you invested a $100, the downside of losing the $100 is not a big deal.  However, if you only had $1,000 the downside of losing $100 would be substantial.   The ability to absorb the downside varies greatly from person to person, from business to business.  If you typically meet or beat your schedules, you can “afford” a slip up, while someone who has already missed several deadlines can’t “afford” another one.

Necessity of the Upside The greater the need, the higher the tolerance for the downside outcome in pursuit of that need.  If the survival of your business and job depends upon getting a product or service to market by a certain time, you may have no choice but to set a very aggressive schedule, i.e. even one with an uncomfortable probability of failure.

Putting this all together – What’s the downside, what are the chances of this happening, can I control the outcome (raise the probability that the bad outcome won’t happen), can I absorb the downside and how much do I need the upside?   Add some psychology to the mix and you decide if the initiative is “too risky” or “OK”.

The Takeaway Measuring and acting on Risk can’t be accomplished by just plugging factors into an equation.  However, by becoming clear on what the downside is, what the assumptions are behind the uncertainties (probabilities), how you might be able to control (change) those probabilities, how you could mitigate and/or absorb the downside, and what the necessity of the upside is, can go a long way in helping you  access the risks and make the decision.

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