Develop your risk-taking muscle

By Alastair Dryburgh via   Article

Why You Need To Develop Your Risk-Taking Muscle, Now

“Consider a choice of these investment projects, each of which cost $1 million.

• Project 1 offers a 90% chance of a return of $1.33 million

• Project 2 offers a 75% chance of  a return of $1.866 million

• Project 3 offers a 60% chance of a return of $2.67 million

• Project 4 offers a 50% chance of a return of $3.6 million

• Project 5 offers a 25% chance of a return of $8 million

• Project 6 offers 10% chance of a return of $30 million

In most established organisations, project 1 would be the most favored, followed by 2, and then 3 and so on. Project 1 offers a reasonable return, and seems like almost a sure thing. As you move down the list, the risks become progressively less appealing. This is the natural, ‘human’ way of looking at things. However, these figures have been constructed in such a way that the natural human assessment is exactly the opposite of the rational. Look at the expected values of the projects – that is, the value of success multiplied by the probability or, if you prefer, the average return you would receive if you ran the project many times. This is what you see:

Project 1 – $1.2 million

Project 2 – $1.4 million

Project 3 – $1.6 million

Project 4 – $1.8 million

Project 5 – $2.0 million

Project 6 – $3.0 million

The order has been exactly reversed! The riskier the project, the more attractive it is, when you analyze risk and reward mathematically.

This bias can have different levels of consequences. If there are enough low-risk projects available, it doesn’t stop an organisation having a reasonable future. There are more exciting prospects, but if the low-risk strategy is good enough then life can be OK. …

The real problem arises when there just aren’t enough low-risk propositions available even to keep the business where it is. This can happen if the market moves and the business needs to follow it into new areas, or there is a change in technology requiring substantially new products. Or it might simply happen as the market becomes more competitive over time and the low-risk space becomes too crowded – too many people looking for the sure thing.”

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