Risk from the Managers Perspective (Part 2)

Daniel Dumke — Fri, 12 Nov 2010 11:37:00 +0000

Today I will write about the implications of the risk understanding by managers covered in Part 1 of this series. After observing the mentioned factors on how managers perceive risks the authors categorize their conclusions in three areas.

Insensitivity of Risk Taking to Probability Estimates

[Decision makers] do not trust, do not understand, or simply do not much use precise probability estimates.

This quote summarizes one of the major findings. Probabilities – not risk at large – are not well understood and handled by managers. This is especially fatal when considering disruptions, events with low probabilities but high adverse effects. Because these events are then ignored since managers are overwhelmed by their sheer number. And of course this leads to organizations which are always surprised by events that they did not think of.

In some of my interviews during my research with business executives I spotted the same behavior: supply chain managers that never have thought of the possibility of a strike, a fire or another catastrophe. But the number of managers on the other end – so really managing these risks – seems to be even lower.

The Importance of Attention Factors for Risk Taking

Empirical research – as for example in Part 1 – indicate that risk preference varies with the context in which the decision has to be made. This includes everything from individual feelings of the manager, how and by whom the data is presented, the company context, etc.

In human decision making there is always the tendency to focus on a few key aspects of a problem at a time. Therefore it is of the utmost importance to define and calculate the key metrics correctly, but often not only the measures may pose a problem but also the target levels to assess performance (eg. break even) and survival levels. These two reference points partition possible states into three: success, failure, and extinction; and with that massively influence decision making in each of the three categories

Risk Taking, Gambling, and Managerial Conceit

Managers do care a lot about their reputations for risk taking, on the other hand are eager talk about how they assess the qualities of others in this regard and on the inadequacy of organizational incentives for making risky decisions intelligently. So risk taking seems to be a very important part of their definition of life as a manager. It is important to take risks, but not to “gamble”.

Hence, it is amazing to see that managers are still rewarded for good outcomes rather than good decisions (making).
The authors see this point very critical

Society values risk taking but not gambling, and what is meant by gambling is risk taking that turns out badly. Thus, risky choices that tum out badly are seen, after the fact, to have been mistakes. The warning signs that were ignored seem clearer than they were; the courses that were followed seem unambiguously misguided.

Conclusion

The authors conclude with the following recommendations for the proceeding:

Short run: Measures have to be designed which accommodate for these findings, but more importantly there has to be a concept on how to steer risk taking by managers.
Long run: These findings might have implications for the education of managers to improve the individual risk taking.

We may prefer to have managers imagine (sometimes falsely) that they can control their fates, rather than suffer the consequences of their imagining (sometimes falsely) that they cannot.

This article has been written in 1987, nearly one generation ago, but to be honest I believe most of the results are still true nowadays (to my knowledge there has not been another similar study, yet). Sadly, I do not think that neither companies have improved decision making nor education has picked up much. In my point of view the handling of decision making under uncertainty should be supported by IT and the organization.

Reference:

March, J., & Shapira, Z. (1987). Managerial Perspectives on Risk and Risk Taking Management Science, 33 (11), 1404-1418 DOI: 10.1287/mnsc.33.11.1404

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Risk from the Managers Perspective (Part 1)

Daniel Dumke — Wed, 10 Nov 2010 08:43:00 +0000

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.

The last point is supported by a common quote:

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.

Reference:

March, J., & Shapira, Z. (1987). Managerial Perspectives on Risk and Risk Taking Management Science, 33 (11), 1404-1418 DOI: 10.1287/mnsc.33.11.1404

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