As a business advisor, commercial lawyer and owner manager risk is baked into everything I do. After fourty years in business, here are some of my thoughts on risk from an owner manager’s perspective.
The four variables of risk
Risk is the intersection of four variables – probability, certainty, consequence and choice.
I am going to organize my thoughts on these variables in reverse order. In my experience risk discussion is generally weighted to probability, with a fair proportion thereafter to uncertainty, some to consequence, but very little is said about choice.
But first, some definitions:
Risk a perception of hazard or opportunity on which a choice will be or has been made.
Probability the relative frequency at which an event occurs or is estimated to occur e.g., 1 in 10.
Certainty the degree to which we know or do not know something of importance, including probability and consequence.
Consequence the impact of our choices on ourselves and others.
Of the four variables choice is the least written about and yet the most important. Choice is the action that results from the consideration of risk, and choice ensures that all risk assessment and risk management is and will be uniquely subjective and circumstantial.
In the context of risk and owner managers:
- Choice is subjective. Different people will make different choices even if they share the same risk perception.
- Choice is circumstantial. The same people may make different choices on the same risk perception at different times and in different situations.
- Choice is subject to bias and heuristics.
- Choice is subject to our past experiences.
- Choice is subject to our ambitions, and what we want or do not want for ourselves.
- Choice is subject to what we want or do not want to see happen to others, including affection and enmity.
- Choice is subject to our tolerance for uncertainty and ambiguity, and the extent of our need for certainty.
- Choice is subject to how we appear or want to appear to others, including peer pressure.
- Choice is subject to our emotions as well as our intellect, including fear and greed.
- Choice can be rash, brazen, craven and unpredictable.
- Doing nothing is a choice (and an action).
- Choice can be instant, instinctive and subconscious.
- Choice can be paralyzing and debilitating.
In managing choice in the context of business risk and owner managed businesses, here are some considerations:
- Begin by establishing your tolerance for negative outcomes.
- Beware of adjusting your tolerance to suit the risk. Tolerance should only be adjusted consciously and as a last resort.
- Ensure you have multiple choices and have fairly considered all of them. The point of risk management is comparative risk analysis leading to a choice between competing perceptions.
- Fewer choices are better than many. Use the process to narrow the choices to a few.
- Simple choices are better than complicated ones.
- Rank the choices. The process of ranking can bring clarity.
- Consider deferring the choice, and not making it before you must – keeping in mind that deferring choice can be a risk itself.
- Consider sequencing the choices. Do not confuse a choice in the process for a final definitive choice. Sometimes the definitive choice is further into the process than you first thought.
- Do not confuse reversible with irreversible choices. Sometimes the irreversible choice is further into the process than you first thought.
- Do not confuse irreversible with reversible choices. Sometimes there are not second choices and no going back.
- Do not be afraid to use rules of thumb to help you choose, provided they have a solid track record.
- Look for choices you have not considered, for choices “outside the box”.
- Consider perspective and look at your choice from others’ viewpoints.
- Do not confuse choice with risk. Risk is a perception. Choice is an action. They each have validity independent of the other.
- Do not confuse choice with uncertainty. Uncertainty is a variable in risk perception. Choice and certainty each have validity independent of the other.
Consequence is what we are trying to avoid or obtain.
In the context of risk assessment for owner managers:
- Consequence can be negative or positive, a loss or a gain, a hazard or an opportunity.
- There should be at least two consequences to be considered, and there often a lot more than two.
- You should have a range of consequences and probabilities assigned to each, even if that range is a data set of two – all or nothing.
- Accepting that in simple terms risk = probability X consequence, then consequence has a multiplier effect.
- A low consequence really brings risk down. For example, that low consequence makes it easy for so many people to play the lottery. The high probability of losing a small amount of money does not look so bad compared to the low probability of winning a large amount of money.
- On the other hand, if consequence is existential (like bankruptcy or the end of an important relationship) even a low probability of occurrence can make the risk extreme and daunting.
- Consequence is emotional and that emotion will also have a multiplier effect.
- Emotion can increase the perception of both negative and positive outcomes.
- It is human nature to overestimate existential risk, or any risk associated with fear or loss.
- Consequence should be objective.
- Consequence should be measured and quantified.
- Probability and certainty should be applied across the range of possible consequences.
- Consequence might be reversible or irreversible and should be noted as such.
- Consequence should be considered from several perspectives including yours and others.
- Do not overlook unintended consequence, which is often revealed by considering the perspectives of others.
- Do not overlook reaction as consequence. Just as your choice is an action, so will your choice inspire choices by others.
- Do not overlook consequences that arise from doing nothing or delaying.
- Consider opportunity cost (e.g., what else you could with your time, effort or money).
- We commonly apply probability (likelihood of occurrence) to consequence, but we often forget to apply certainty (how confident we are in our likelihood calculation). Assess and apply certainty to consequence, keeping in mind that certainty should be mathematical and can be a range.
- Do not confuse certainty of consequence (how sure or unsure we are of the effect of our choice) with certainty of probability (how sure or unsure we are of the likelihood of that effect occurring).
During the process of risk assessment and risk management certainty can be the least considered and most debated variable.
How can we be sure we know what we know?
How reliable are our assumptions?
How do we know what we do not know?
These are valid and often emotionally vested concerns.
In the context of owner managed businesses:
- Certainty should be independently verified, if possible, e.g., consulting experts or checking past experience and comparables.
- Avoid rounding when considering certainty. Quantify it to a single decimal place.
- Accept that certainty can be a range and set out the range.
- Apply certainty to both probability and consequence.
- Uncertainty has a multiplier effect, where risk can = (probability ÷ certainty-as-a-percentage) X (consequence ÷ certainty-as-a-percentage). The higher the certainty the narrower the range of possibilities, and the higher the uncertainty the wider the range of possibilities.
- Beware of the illusion of certainty. Solid snow can hide a deep crevasse. Probe and keep probing.
- Check the sources and consider their credibility.
- Check the sources and consider their bias.
- Check the sources and consider their quality.
- Check the sources and consider their source data.
- Check the sources and look for assumptions, gaps, exclusions, oversight and selectivity.
- Beware of moral hazard and sources with nothing to lose.
- Certainty should be dispassionate; be wary of passionate certainty.
- Certainty can be emotional.
- We tend to overestimate certainty related to what we are afraid of or what we most want.
- We overestimate certainty when we believe we know what we are talking about.
- Conviction does not improve certainty.
- Expertise does not by itself improve certainty.
- Beware of tunnel vision in assessing certainty.
- Certainty should be objective, verifiable and measurable.
- Subjectivity should only play out in choice; it should have nothing to do with certainty.
- Measure twice, or three times.
- Check the formulas in the cell, as well as their output.
- Quantity of information is no substitute for nor the same as quality of information.
- Too much information can be a source of uncertainty.
- It is natural for us to prefer certainty to uncertainty.
- Simple certainties are more useful than complex ones.
- It is often better to be roughly right than precisely wrong.
- Certainty should not be skipped.
- Certainty should not be confused with risk or probability.
In risk assessment probability is often where most time and money are spent, even though it is only one of four key variables.
Some thoughts about probability in the context of owner manager risk include:
- Do not confuse probability with certainty. The likelihood of an occurrence (probability) should not be affected but how much we know about that likelihood (certainty). You can be 100% certain you have a 1 in 6 likelihood of rolling a 6 with a perfect six-sided die, but that certainty does not affect that probability.
- Do not confuse probability with risk. Probability is an exercise in quantification. Risk is a perception leading to a choice.
- Probability should be as unemotional as possible.
- Probability should be reasonably mathematical.
- Avoid rounding. It is better to take probability to a single decimal point.
- Avoid absolute risk calculations and prefer relative risk calculations. One number by itself without context is much less revealing and more subject to emotion and bias than one number compared to another.
- Avoid expressions of percentage risk and prefer expressions of natural frequency.
- Probability can be a range, and often is.
- Probability can be ranked, and often should be.
- Probability should account for heuristics and bias.
- Probability should account for luck and randomness.
- Probability should account for streaks, good or bad.
- Probability should consider that “normal” changes and moves around over time and with changes in circumstance.
- But probability should not lose sight of regression to the mean and should account for that.
- Probability should consider standard deviations and consider dropping the outliers.
- Probability should consider the bell curve, but not too much.
- Probability should allow for the unknown unknowns.
- Probability should consider several perspectives from more than one observer.
- The certainty of probability is not proportional to the complexity of the calculation.
- Probability can be instant, instinctive and subconscious.
- Rules of thumb have a valid place in probability.
- Expertise does not guarantee certainty of probability, it can in fact hinder it.
- Probability can be subject to continuous updating right up until the choice is made.
- A single outcome does not prove nor disprove probability.
Some concluding thoughts
Better understanding of risk, better assessment of risk, and better perceptions of risk, should lead to better choices.
But not always.
In business, the deal you pass on today could be your competitor’s great leap forward and your greatest regret.
Or the sure bet you take up today could be your undoing tomorrow.
For included in everything we know about risk is the knowledge that in a long run of multiple frequencies even the low probability of a significant consequence will occur someday, and that could be gains and losses, hazards and opportunities, positives and negatives.
So why not today?
So why not to me?
Two of life’s most emotional and subjective questions.
And which is why, in the end, it really comes back to choice. Research, mathematics, statistics, experience, expertise and opinion or tools to help you choose, but in the end choose you must.
© Phil Thompson – www.philthompson.ca