Much of the commentary about behavioral economics warns against overconfidence when it comes to managerial practices. The concern is that human behavior might lead managers to overstate the likelihood of a project’s success and minimize its downside. The financial crisis certainly stirred debate over that kind of bias. But often overlooked in that debate are reward systems that lead managers to become so risk averse that they pass over projects even when the potential earnings are far larger than potential losses.
Midlevel executives making repeated decisions about the many smaller investments that a company might make—valued at, say, $20 to $40 million— should be risk neutral—not overweighting negative or positive outcomes relative to their actual likelihood of occurring. Such projects include expanding a sales force at a consumer-goods company into a new geography, for example, or extending a product line at an electronics firm. Decisions about projects of this size don’t carry the risk of causing financial distress—and aversion to risk at this level stifles growth and innovation. Moreover, when a large number of projects are in play risk aversion is unnecessary because statistically, they’re extremely unlikely all to fail (unless they are highly correlated to the same risks).
Yet managers at this level exhibit an unwarranted aversion to risk. Our research suggests that when faced with multiple variations of the same small- to mid-sized project the typical manager will choose a smaller investment with lower up-front costs over a larger one with a longer payback period. As long as the smaller option is enough to meet his own earnings goals, the additional risk of a larger project more than outweighs the benefits to him—even if it presents little additional risk to the company and even if that additional risk is more than offset by an increase in net present value. That natural bias against risk is often exacerbated by a company’s capital-allocation and evaluation processes. As a result, many companies wind up with risk aversion at the corporate level that resembles that at the individual level—squandering the risk-bearing advantages of size and risk pooling that should be one of their greatest strategic advantages.
Much of the typical risk aversion related to smaller investments can be attributed to two well-documented behavioral biases. The first is loss aversion, when people fear losses more than they value equivalent gains. The second is narrow framing, when people weigh potential risks as if there were only a single potential outcome—akin to flipping a coin only once—instead of viewing them as part of a larger portfolio of outcomes—akin to flipping, say, 50 coins.
We frequently run across CEOs stymied by their company’s struggle with risk; decisions that may be in the best interests of individual executives, minimizing the risk of failure, are actually harmful for their companies. As the CEO at a manufacturing company observed, his company’s business unit leaders gravitate to relatively safe, straightforward strategies with earnings goals that seem reachable, even if they mean slower growth and lower investment along the way. We have also heard from many nonexecutive board members that their companies are not taking enough risks.
Companies can reduce the effects of risk aversion, where appropriate, by promoting an organization-wide attitude toward risk that guides individual executive decisions. More specifically, companies should explore the following:
- Up the ante on risky projects. Risk-averse organizations often discard attractive projects before anyone formally proposes them. To encourage managers and senior executives to explore innovative ideas beyond their comfort levels, senior executives might regularly ask them for project ideas that are risky but have high potential returns. They could then encourage further work on these ideas before formally reviewing them.
- Consider both the upside and downside. Executives should require that project plans include a range of scenarios or outcomes that include both failure and dramatic success. Doing so will enable project evaluators to better understand their potential value and their sources of risk. These scenarios should not simply be the baseline scenario plus or minus an arbitrary percentage. For example, when evaluating the introduction of a new consumer-goods product, managers should explicitly consider what a “home run” scenario would look like—one with high market share or high realized unit prices.
- Avoid overcompensating for risk. Managers should also pay attention to the discount rates they use to evaluate projects. We repeatedly encounter planners who errantly use a higher discount rate simply because an outcome is more uncertain or the range of possible outcomes is wider. Higher discount rates for relatively small but frequent investments, even if they are individually riskier, do not make sense once projects are pooled at a company level.
- Evaluate performance based on portfolios of outcomes, not single projects. Wherever possible, managers should be evaluated based on the performance of a portfolio of outcomes, not punished for pursuing more risky individual projects. Then their personal performance would be evaluated based on various combinations of outcomes—some more successful, some less.
- Reward skill, not luck. Companies need to better understand whether the causes of particular successes and failures were controllable or uncontrollable and eliminate the role of luck, good or bad, in structuring rewards for project managers. They should be willing to reward those who execute projects well, even if they fail due to anticipated factors outside their control, and also to discipline those who manage projects poorly, even if they succeed due to luck.
Tim Koller is a partner in McKinsey’s New York office, where Zane Williams is a consultant. Dan Lovallo is a professor at the University of Sydney Business School, a senior research fellow at the Institute for Business Innovation at the University of California, and an adviser to McKinsey.