What is risk?  When a lot of us hear this word, we automatically think that it has something to do with something bad happening.  What is risk management?  When a lot of us hear this phrase, we automatically think of “Along Came Polly.”  Risk and risk management almost always equates to incredibly awful downsides whether it be in our drive to work (car crashes), our retirement accounts (stock market crashes), or our health (heart crashes).

When we consider risk this way, we are putting unfair weight on the downside of what risk really is.  Risk is really the measure of the unexpected, and the unexpected can work in our favor as well as against us.  That means that even a crazy unexpected positive outcome, like winning the lottery, is also as much of a reality of risk as a plane crash (on island which travels through time for all the LOST fans out there).  Risk is saying that there is a range of outcomes that could happen and we don’t have a clue about what the hell is going to happen in the future.  The wider that range of outcomes, both good and bad, the more risky something is.

Peter L. Berstein, author of Against the Gods: The Remarkable Story of Risk, explains it pretty well.  He says by definition risk is a measure of the unknown, and because of that it is silly to presume and act as if we know what the future holds.  Risk management really is understanding that the future is uncertain, and preparing ourselves and our institutions to deal with the times when things are different from our expectations:

I was particularly intrigued by his comments about using optionality models in corporations as a way to value the option of waiting as an alternative strategy to acting, primarily when making decisions that you can not go back and change.  This is putting a value on the new information you can gain through the passage of time, simply by sitting back and waiting.  Most people, especially in the start-up space, say there is no time for waiting, release early and release often, iterate iterate iterate.  But what if the cost of this far out weighs the value of waiting?

Say your company is launching a new product, and you have to decide how to spend a $1 million dollar budget to advertise it’s awesomeness to the world.  Your marketing division comes to you with a proposal allocating dollars to buying Google Ad Words, a full-page ad in your industry’s top trade magazine, and a viral video campaign.  In passing they mention that the behavioral study of your existing customer base is going well, and the results should be ready in three six nine months, in time for the industry trade show.

We usually get a lot of information about how search engine marketing has the highest brand recall and  video has the best consumer retention rate and the top ten sites that have the exact demographic that we are targeting.  However this information doesn’t guarantee success; the future is completely unknown and its outcomes could range from the greatest advertising campaign of all time to the the most colossal failure destined to be top business school study material (Advertising Mismanagement:  A Case on (Insert Your Company Name Here).  But what is the value of waiting for more information to launch our advertising campaign, specifically our behavioral study?  What if spending $50,000 to finish up the study tells us exactly who to target, and we only need to spend $500,000 to reach them?  Wouldn’t that trade-off be awesome information to have?  This is possible by modeling the value of waiting to act on future information!  This would certainly help in trying to avoid “being too early,” something that venture capital firms often express concerns about.

So we know understand that risk is more than just danger, and really a representation of ranges (positive and negative) of what an outcome can be.  Risk management is really preparing ourselves for the range of outcomes that could happen, and better risk management would also involve valuing what a “wait and see” approach would be.  We do not know what the future holds, so it’s okay to make mistakes, and the sooner we realize that we can’t do anything about uncertainty (that’s not to say we can’t do anything to mitigate the impact of adverse situations), then the sooner we can be happy as a hippo.

2 Responses to “What is Risk?”

1. Glenn says:

   June 11, 2009 at 10:25 am

   Thanks for reblogging this important video from such a luminary in finance. Bernstein is advocating the use of the financial instrument known as options in this interview about risk. You have recontextualized this message as a cautionary tale for starts ups who rush in where angels fear to tread, so to speak. In both situations, it is recognized that risk is closely tied to the unknown. I think that the key differentiator is his point about irreversible decisions. The knowledge gained from waiting may outweigh the knowledge gained from acting when the action is irreversible. The “fail fast” notion of the start up is more about learning through iterating very quickly and cheaply with experiments that can easily be undone. Thus, we have an apples and oranges situation because Bernstein is talking about irreversible decisions whereas the start up is iterating with reversible decisions.
2. Rathan Haran says:

   June 11, 2009 at 3:26 pm

   I see your point, and in most cases I think that the value of waiting will be downright low compared to iterating. However, I think there is a bigger point to be made here; using optionality modeling as a way for entrepreneurs to enter the market at the right time, rather than “too early.” A lot of great products have entered the market when the market was just not ready for them, and unfortunately the start-up budget is relatively small so timing begins to matter. VCs are already thinking this way, but they don’t have a science to put a hard dollar to what waiting for more information is worth. Maybe that’s another start-up idea!