In tight financial times, it’s smart to be conservative when it comes to risky investments. But new research shows those with decision-making power may be playing it just too safe.
A strict adherence to risk aversion may be a real problem with some businesses, as research from McKinsey Quarterly (via Wall Street Journal) suggests.
Imagine this scenario: You’re faced with two investment opportunities. You can 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 dip in earnings in the early years. In each case, the chance of failure is the same.
According to research, when faced with multiple variations of the same small- to mid-sized project, like the aforementioned scenario, a typical manager will choose the smaller investment over the larger investment. As long as that smaller option is enough to meet earnings goals, the risk of a larger project outweighs the benefits. Keep in mind, the latter presents little additional risk to the company and that additional risk is offset by an increase in net present value.
So, what does it all mean?
It means that managers are too comfortable with playing it safe, and it may be happening in your company right now, costing you potential gain.
McKinsey offers five things you can do to make sure your team isn’t running from risk.
1. Encourage managers and senior execs to explore ideas beyond their comfort zone. Ask for project ideas that are specifically risky but offer high returns. From there your team can alter those plans before a formal proposal.
2. Explore every scenario. Ask yourselves, “What will happen if this is an absolute failure? What will happen if it’s a complete knockout success?” Be prepared for every single outcome there could be.
3. Don’t use a higher discount rate when evaluating just because an outcome is more uncertain. If you’re concerned about risk exposure, adopt a rule that any investment amounting to less than five to 10 percent of the total investment budget must be made in a risk-neutral manner with no adjustment to the discount rate.
4. Evaluate managers based on performance of a portfolio of outcomes, instead of punishing for pursuing risky individual projects.
5. Eliminate the role of “luck,” good or bad. Evaluate how well project managers actually performed and don’t just look at the end result.