Risk from the Managers Perspective (Part 1)

Today I finally read one of the most cited articles on subjective risk in general. In 1987 March and Shapira set out to shake up the existing theories on the perception and processing of risks by managers. Accordingly, they aggregated the information from various surveys on this topic.

The article is called “Managerial Perspectives on Risk and Risk Taking” and it can be downloaded here as PDF and I really recommend reading it.
In the first part I will analyze major empirical findings on how managers perceive risks, the second part will cover the implications from that and will be published this Friday.

Definition of Risk

Usually risk can be defined as a combination of an outcome and uncertainty / probability component. And most people would agree: An alternative with higher outcome is better and one with more uncertainty is worse. Decision theory therefore used the concept of the variance of the outcome distribution to describe risks and many models are based on this. But does this reflect how managers defines risks?

Probably not, the authors show that…

• Most managers do not care about uncertainty of the positive outcomes: Eighty percent of the executives said they considered the negative ones only
• For managers risk is not so much about probability, but much more about the magnitude of possible bad outcomes, so managers do not seem to be risk averse in general but more loss averse (with a clear focus on the amount not the probability)
• Although many managers use numbers for quantifying risks and 42% argued that there was no way to translate a multidimensional phenomenon into one number. Interestingly 24% of the same managers felt it could be done and with additional probing said that actually it should be.

A senior vice-president observed: “You don’t quantify the risk, but you have to be able to feel it.”

Attitudes toward Risk

It has been acknowledged for some time now that decision makers do not necessarily act purely rational, so several concepts of risk aversion have been developed from a theoretical point of view. But how do managers think about risks.

• There are individual differences on the degree of risk aversion, but these differences are less influential than other differences in “incentives and normative definitions of proper managerial behavior”
• Some managers show a very negative attitude towards individual risk taking (vs. group decision or “gambling”), this behavior is particularly characteristic of managers who see risk as single construct of the magnitude of the expected loss (ignoring the probability)
• Managers tend to believe they are greater risk takers than they are in reality
• Motivations to take risks
• Risk taking is essential to success in decision making
• Risk taking is an expectation on their job
• Emotional pleasures of risk taking
• Most managers would take more risks when faced with a failure to meet targets than when targets were secure. Furthermore, managers would take riskier actions when their own positions or jobs are threatened then when they are safe

Dealing with Risk

In theory dealing with risks is easy since there are alternatives to choose from and depending on the individual definition of risk and the risk preferences (see above) the correct decision is made. But the behavior of the decision makers shows distinctive features as well.
Very often manager focus on ways to reduce the negative outcomes while retaining the gain of a given alternative. The easiest way to do this is to reject the estimates which form the basis of the proposed alternative. And even after doubting the odds executives still feel that they will be better of since they expect being able to avoid the risks using their experiences.

Go on reading Part 2.