Here is a brief excerpt from an article in The McKinsey Quarterly, published by McKinsey & Company, in which Tim Koller, Dan Lovallo, and Zane Williams explain how risk-averse midlevel managers making routine investment decisions can shift an entire company’s risk profile. An organization-wide stance toward risk can help. To read the complete article, please click here.
Source: Corporate Finance Practice
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Here’s a quick test of your risk appetite. Your investment team has approached you with two variations of the same project: you can either invest $20 million with an expected return of $30 million over three years or you can invest $40 million with an expected return of $100 million over five years (and a bigger dip in earnings in the early years). In each case, the likelihood that the project will fail and yield nothing is the same. Which would you choose?
Much of the commentary about behavioral economics and its applications to managerial practice, including our own, warns against overconfidence—that biases in human behavior might lead managers to overstate the likelihood of a project’s success and minimize its downside.1 Such biases were certainly much debated during the financial crisis.
Often overlooked are the countervailing behavioral forces—amplified by the way companies structure their reward systems—that lead managers to become risk averse or unwilling to tolerate uncertainty even when a project’s potential earnings are far larger than its potential losses.2 In fact, the scenario above is based on the experience of a senior executive in a global high-tech company who ultimately chose the smaller investment with the lower up-front cost. That variation of the project would allow him to meet his earnings goals, and even though the amount of additional risk in the second variation was small—and more than offset by a five-fold increase in the net present value—it still outweighed the potential rewards to him.
For projects of this size at a large company, the profit forgone by choosing a safer alternative—putting less money at risk with a shorter time to payoff—is modest: in this case, about $20 million. But the scenario becomes more worrying when you consider that dynamics like this play out many times per year across companies, where decisions are driven by the risk appetite of individual executives rather than of the company as a whole. In a single large company making hundreds of such decisions annually, the opportunity cost would be $2 billion if this were to happen even 20 times a year over five years. 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.
Mitigating risk aversion requires that companies rethink activities associated with investment projects that cause or exacerbate the bias, from the processes they use to identify and evaluate projects to the structural incentives and rewards they use to compensate managers.
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The corporate center must play an active role in implementing such changes—in setting policy, facilitating risk taking, and serving as a resource to help pool project outcomes. It will need to become an enabler of risk taking, a philosophy quite different from that currently expressed by many corporate centers. The office of the CFO should also be involved in oversight, since it is particularly well suited to serve as manager of a company’s portfolio of risks, making trade-offs between them and taking a broader view of projects and the effects of risk pooling.
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Tim Koller is a partner in McKinsey’s New York office, where Zane Williams is a senior expert. Dan Lovallo is a professor at the University of Sydney Business School, a senior research fellow at the Institute for Business Innovation at the University of California, and an adviser to McKinsey.