As a new General Manager, you’ll have to start making decisions, and its good to have some background on Decision Theory. So here’s some basics on how to think about decisions, and how to assess what sort of risk taker you are.
Risk aversion
OK, imagine the following, you are offered a strategy that will give you a 50/50 chance of earning $1,000 profit. You have P = 0.5 of getting $1,000 and P = 0.5 of getting 0.
Or you can choose not to play the game and make $300.
What do you do? Ahh, you think, small money, lets give it a go, right?
The answer is: it depends on who you are and what your risk preferences are. Ok but here the stakes are not so high. So lets up these stakes a little.
Now your team brings you a strategy that will give you a 50/50 chance of earning $100,000 profit. You have P = 0.5 of getting $100,000 and P = 0.5 of getting 0.
Or you can choose not to play the game and make $20,000.
Now what do you do?
Rationally, the number to get you to walk away should be $50,000. But most people will walk away for less. Sometimes much less. Sometimes people will walk away for $5000 or $10,000. After all, it’s profit they didn’t have before and better to have some to show the Boss rather than nothing.
Anyone who accepts less than $50,000 to walk away is known as risk-averse.
Loss Aversion
Now lets do something different, that often happen in business situations, let’s turn the experiment on its head.
Now you have a 50/50 chance of either losing $100,000 or breaking even.
But to make it interesting you can either take your chances with the 50/50 strategy or you could lose a certain $20,000 and walk away.
Faced with this choice, typically people will take the bet on the strategy breaking even.
The psychology is that nobody wants to “lock in” a guaranteed loss. As long as there is a chance that they could break even, they will hope—except hope is never a strategy.
This hope is known as loss aversion.
Congratulations, if you understand this experiment, you understand half of behavioral finance, and you’ve found out if you are risk averse or loss averse.
Think like an Economist
I’d like to introduce two Economists to you. Daniel Kahneman is quite famous, with his book Thinking Fast and Slow, and Richard Thaler is perhaps even more famous, with his books Nudge and Misbehaving. He is also an advisor to US President Obama. Together they did a lot of work on Risk aversion and Loss aversion described above.
They were able to use these theories about risk and loss to explain why stock markets “go up on an escalator and down in an elevator”. People are happy taking tiny profits on the way up (afraid of the risk of losing the increase in value) and but are loss averse (they don’t sell and let the losses mount on the way down, hoping the market rebounds).
Human beings are just not set up to best understand risk. Both parts of the experiment I talked about above are illogical. The first part is known as “taking profits too soon” – people are happy to walk away with a smaller amount to guarantee a benefit. The second part is “letting losses run” – the same people, when faced with a guaranteed loss, hope that they’ll win big, rather than accepting a smaller loss and walking away.
Let’s talk about how these two natural behaviours can impact your business. The first review is about letting losses run. This is the mistake beginners make.
I buy a stock at $50. It goes to down to $48. No big deal. It goes to $46. I could have sold it at $48. I now I definitely can’t sell it at $46. It crashes to $40. Now I’m really in trouble. If I sell now, it would be catastrophic. I hope, pray, that it will come back. And then it goes to $20.
The informed businessman sells when it goes to $48, accepting a small loss on the basis he has no new information that will bring the stock back up.
But the informed businessman makes a different sort of error. He buys Apple at $50, sells it at $55, and then he’s shocked when it goes to $700.
In many ways, this is much more catastrophic. Markets do go up over time, and frequently, new businessmen will get bailed out because of this.
But you can’t undo buying Apple at $50 and selling it at $55, you lost $645 of upside.
This is why entrepreneurs win big- they are willing to bet on themselves, accept the complete loss of their investments to win big should their idea succeed. This is why most businesses survive recessions as they are used to exiting bad strategies for small losses.
So what can you learn? Are you risk averse? Are you loss averse? Bring this insight to mind when you next look over a business plan or strategy to ensure you think with your head and not with your heart.