Business Strategy SeriesWhat do strategists mean when they talk about risk?Philip A. Wickham

Article information:To cite this document:Philip A. Wickham, (2008),"What do strategists mean when they talk about risk?", Business Strategy Series, Vol. 9 Iss 4 pp. 201 - 210Permanent link to this document:http://dx.doi.org/10.1108/17515630810891870

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What do strategists mean when they talkabout risk?

Philip A. Wickham

Introduction

Few debates about strategy fail to mention risk. Yet risk is a neglected idea in much formalstrategic thinking. The classic summary of major contributions from the 1970s and 1980s,Weitz and Wensley’s Readings in Strategic Marketing has no index reference to risk (Weitzand Wensley, 1988). Nor does Michael Porter’s highly influential Competitive Strategy(Porter, 1980). The recent Oxford Handbook of Strategy, (Faulkner and Campbell, 2006) atnear 1,000 pages has seven index references to risk. Even here comments are passing. Fiverelate corporate diversification to reducing risk, one suggests that more limited opportunitiesfor product testing impose higher risks on service organisations compared to manufacturingand one draws a formal distinction between risk and uncertainty. This is not intended to becritical; all of these are excellent and rightly influential books. However it does show theextent to which the idea of risk is neglected within strategic management and when it ismentioned, the degree to which strategic thinking borrows from finance and economics.

Ruefli et al. (1999) make a call for a broader range of approaches to thinking about risk instrategic management. This is a major opportunity. Modern economic psychology hasdeveloped a broad and rich picture of risk, not just as a technical concept, but as somethingthat influences the way in which strategists think and make decisions about risk and actwithin their risky worlds.

Strategic management has distanced itself from the notion that strategy development is amatter of programming the organization with a strategic plan (Mintzberg, 1994) to one wherestrategy creation is a process incremental crafting (Mintzberg, 1988; Courtney, 2001). Sospace exists to integrate the idea of risk as a psychologically human feature of strategists’decision-making and behaviour as well as the economic idea that appears in finance theory.

This article explores eight perspectives on risk and invites strategic managers to think aboutrisk in a fuller way. After a (brief) account of risk as it appears in finance and economics thearticle considers risk as something that enters into strategic managers’ debates, assomething that influences strategic choice, as something that influences managerialbehaviour, as a factor in position and status (for individuals and organisations), as somethingthat affects the way strategic managers think about and deal with information and, finally, assomething that, like resources, is shared between the organisation and its stakeholders. Thearticle concludes with some ideas on how strategic managers might develop a more holisticand integrated perspective on the risks they manage. A check list of questions that illuminatedifferent facets of strategic options risk is provided.

Eight perspectives on risk

1. Risk: its technical interpretation

The formal interpretation of risk can be traced back to the Enlightenment and concerns withwhat is just in gambling (Bernstein, 1996). An early idea is that a fair reward for a gamble is

DOI 10.1108/17515630810891870 VOL. 9 NO. 4 2008, pp. 201-210, Q Emerald Group Publishing Limited, ISSN 1751-5637 j BUSINESS STRATEGY SERIES j PAGE 201

Philip A. Wickham is

Visiting Research Fellow at

the University of

Huddersfield Business

School, Huddersfield, UK.

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the amount that might be won multiplied by the chance of winning that amount. So the

chance to win $10 on the fall of a fair coin on heads should be $10 multiplied by a half or $5. It

quickly became apparent however that this amount overestimated how much most

gamblers were willing to pay to play the bet. Typical, they wanted a premium in winnings to

take on risk. The idea of ‘‘risk aversion’’ was born. All things equal, people prefer less risk to

more. This simple idea (albeit with a lot of mathematical developments) forms the basis of

economic and finance thinking about risk, including the idea of demanding an increased

return for increased risk, a notion central to Capital Asset Pricing Theory and its well known

alpha and beta measures of unsystematic and systematic risk.

In games of chance with coins, dice, cards, etc., the chance (probability) of winning is

known for definite. But many decisions are taken in situations where chances are not known

for definite, or can only be given approximate estimations. Most strategic decisions are like

this. This led to a formal distinction between risk proper (where chances are known) and

uncertainty (where they are not) (Knight, 1921). This is an important distinction. Risk can be

insured against, uncertainty cannot. It leads to the argument that entrepreneurs are not so

much risk takers as people who turn uncertainty into risk so that investors (who are risk

takers) can finance it (e.g. Wickham, 2007a).

It would also seem that we have an aversion to uncertainty that is separate to an aversion to

risk (Ellsberg, 1961). To see this consider the following two gambles: for the first a jar is filled

with 50 black and 50 white marbles. Choose a colour. How much would you be willing to pay

for the chance to win $100 if your chosen colour is drawn at random? Now imagine a jar that

contains 100 marbles. All the marbles are either black or white, but you do not know how

many there are of each. Again, choose a colour. How much would you be willing to pay for

the chance to win $100 if your colour is drawn at random now? Most people are willing to pay

more for the first (risky) gamble than the second (uncertain) gamble. Rationally both should

be valued equally. The distinction between risk and ambiguity is important psychologically

and an individual’s attitude towards risk is quite distinct from her attitude towards ambiguity.

It has been suggested that tolerance of ambiguity is a stable feature of individual personality.

Psychometric scales to measure ambiguity tolerance have been developed (Lamberton

et al., 2005). There is a considerable and growing literature on managers’ reaction toambiguity as distinct to risk (Furnham and Ribchester, 1995). Entrepreneurs also make the

distinction (Teoh and Foo, 1997).

2. Talking about risk

It is interesting to compare risk as defined technically risk defined in more common language

terms. A technical definition of risk, as adopted in finance suggests that risk is related to both

the range of things that might happen and their chance of happening. The Penguin

Reference Dictionary of Economics (Bannock et al., 1987, p. 359), for example, defines

‘‘risk’’ as: ‘‘A state in which the number of possible future events exceeds the number of

events that can actually occur, and some measure of probability can be attached to them . . .

’’

The wider the range of possible outcomes the higher the risk. ‘‘Risk aversion’’ is a preference

for less risk over more. The Penguin Reference Dictionary of Psychology (Reber and Reber,

2001, p. 634) however defines ‘‘risk’’ as ‘‘An action that jeopardises something of value . . . .’’

‘‘ Modern economic psychology has developed a broad and richpicture of risk, not just as a technical concept, but assomething that influences the way in which strategists thinkand make decisions about risk and act within their riskyworlds. ’’

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And ‘‘risk aversion’’ as ‘‘The general tendency to be afraid of taking risks, even when theyalso carry substantial potential gain . . . ’’.

Four key differences are immediately apparent between these technical and commondefinitions of risk. First, the technical definition emphasises risk as a lack of knowledge aboutwhat might happen. The psychological definition emphasises the emotional reaction to thatlack of knowledge. Second, while there is a technical distinction between risk and uncertainty inthat the former is about quantified probabilities, the latter qualitative or estimated probabilities,this distinction is blurred in common usage. Reflecting this, the Naturalistic Decision School(Lipshitz et al., 2001) shifts attention away from the decision problem to the decision-maker’sreaction to it in a way in which strategists would empathise. Orasanu and Connolly (1993)define uncertainty in terms of ill-structured decision problems, uncertain, dynamicenvironments, shifting, ill-specified or competing decision goals, multiple feedback loops,time-constraints, high stakes, multiple players and organizational settings. Lipshitz and Strauss(1997) suggest insufficient understanding, lack of information and conflicted alternatives.

Third, technical risk encompasses the possibility of good things happening as well as bad.The possibility of a sufficiently positive reward (no matter how unlikely) can compensate forthe possibility of any loss. Common usage emphasises the bad; risk is essentially about‘‘downsides’’ rather than ‘‘upsides’’ (Ricci and Molton, 1981; Slovic et al., 1981; Fishburn,1984). Technical approaches to risk can allow for this by invoking the idea of ‘‘loss aversion’’as something additional to risk aversion (Camerer, 2005). Psychologically then uncertaintyinvolves three aversions that can be distinguished: one to risk, one to ambiguity and one toloss. This distinction is not usually made in finance theory.

Finally, finance theory is concerned with financial gains and losses, or at best those thingsthat can have a financial value put on them. Common usage refers to many things with anon-monetary value: reputation and personal well-being, for example. There is also a shift inthe idea of risk aversion. It moves from being about economic preference, to being aboutpsychological fear.

Perception of risk influences the way in which different options are evaluated andimplemented in an organisational setting. In its technical sense risk is a numerical concept.In practice the behavioural response to risk may be based on non-numerical or verbalratings. Projects may be described as having ‘‘high’’, ‘‘moderate’’ or ‘‘low’’ risk. Events maybe described as being ‘‘probable’’, ‘‘likely’’ or ‘‘unlikely’’, and so on. There is a great deal ofinterest in how these verbal ratings relate to numerical estimations of risk (Thiel, 2002). It isclear that individuals do not use verbal terms for risk and chance in a consistent way. Whatone individual rates as ‘‘unlikely’’ for say the chance of a competitor taking a particular actionand an industry affecting political event in a PEST analysis may differ quite widely innumerical probability. What one strategist rates as ‘‘high’’ risk may be quite different fromanother strategist’s understanding of high risk (see, for example, Wallsten et al., 1993; Thiel,2002; Viscusi and Hakes, 2003). As a result, many debates about the riskiness of strategicoptions may in fact be (implicitly) debates about what the individuals mean by terms, not theabsolute risk of the option. While this may lead to misunderstanding, it may not be entirelynegative in that it can facilitate compromise of differing positions within strategic decisionmaking groups (Erev et al., 1991).

So while many strategic discussions might call upon financial measures of risk, more oftenthan not the word is used in its common sense: the strategist is likely to be thinking aboutpossible losses more than gains, is referring to the chances of things happening that may beuncertain rather than probabilistic, be concerned about more than just money and useverbal terms to describe risk that are only weakly related to numerical measures.

3. Risk and choice

Risk influences the choices strategists make. It is clear from both studies of experimentalchoice and observation of strategists’ choices in real-world settings that gains and lossesand their risks do not influence preference in quite the way that financial theory suggeststhey would (or should). The difference is accounted for by four things. First, while financetheory suggests that strategic decision makers should be concerned with absolute financialoutcomes, in practice strategists are usually more concerned with gains and losses relative

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to some reference point. Often, but not inevitably, this is the position before the decision ismade. However, objectives for gains may also influence the reference point. A 10 per centreturn, say, while positive in itself may be disappointing if 20 per cent was expected. Theperformance of competitors may also provide a reference. Second, possible losses loomlarger than gains. A downside perspective means that potential gains must work harder tocompensate for potential losses. Thirdly, probabilities are often not used as straightforwarddecision weights. In particular, low probability events seem to be regarded as more likelythan they are and high probability events less likely. Finally, while strategists tend to be riskaverse when gains are involved, they are often risk seeking when facing losses. Gain riskaversion may be enhanced, while loss risk seeking may be muted by experience andlearning in a particular decision context (March, 1996).

These four ideas are integrated in Daniel Kahneman and Amos Tversky’s, 1979 ProspectTheory, which aims to provide a better account of practical risk choice. This approach makes

a lot of sense. Strategists do evaluate projects on the basis of what they might gain or loserather than (at least in the first instance) how they will change the final profit and lossaccount. Projects may be rejected on the basis that they might lose too much withoutallowing the potential of gains to offer compensation, but the possibility of exceptionally highgains may make unlikely success seem more attractive. Risk seeking in losses can bemanifest by the ‘‘sunk-cost’’ phenomena where more money is thrown into losing projectsrather than the project being exited (Gschwandtner and Lambson, 2006).

Research into the risk taking of firms suggests (somewhat counter intuitively) that firms in a‘‘winning’’ position with improving performance tend to be risk averse whereas firms in ‘‘losing’’positions and with declining performance tend towards risk seeking (Bowman, 1980;Feigenbaum and Thomas, 1986; 1988; Miller and Leiblein, 1996; Maurer, 2004)). This is counterto the predictions of Capital Asset Pricing Theory but is consistent with Prospect Theory.

4. Risk and behaviour

Choice is a process. The outcome of that process reflects the way in which different strategicoptions are valued, rated and ranked relative to each other. This then affects subsequentbehaviour in terms of prioratizing and implementing those options. Support or rejection of anoption on the ground that it is too ‘‘risky’’ or ‘‘uncertain’’ is sensitive to how the idea of risk is

perceived and reacted to.

Lipshitz and Strauss (1997) emphasise that in natural decision making, risk is not merelysomething that is a factor taken into consideration when making choices, but is something thatengenders a particular behaviour. They suggest the ‘‘RAWFS’’ heuristic as a summary of thisbehaviour: attempts to reduce uncertainty; making assumptions when information is missing;a weighting of different options’ pros and cons; forestalling decisions that involve too much riskand suppression of evidence that seems to increase uncertainty. While this response can beuseful in that it simplifies risky situations, poor assumptions, suppression of relevant evidenceand indecisive forestalling can prejudice the quality of strategic decision making.

Sympathetically, Courtney (2001) considers strategic uncertainty as having four levels:

1. Level 1 – clarity of the future around which probabilities can be established;

2. Level 2 – the existence of alternative paths;

3. Level 3 – a broad range of potential future situations; and

4. Level 4 – true ambiguity.

‘‘ The distinction between risk and ambiguity is importantpsychologically and an individual’s attitude towards risk isquite distinct from her attitude towards ambiguity. ’’

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Courtney goes on to emphasise that the response to this uncertainty is not simply one ofmaking choices about preferred strategic options, but one of:

B shaping or adapting;

B deciding to pursue strategic initiative sooner or later;

B focusing or diversifying;

B selecting and deploying strategic tools appropriate for different levels of uncertainty; and

B choosing processes to update and adapt strategies.

Clearly, this emphasis on naturalistic decision making involves features of risk that are notcaptured (at least straightforwardly) by finance theory.

5. Position risk

Finance is more or less exclusively concerned with monetary gains and losses and theirassociated risks. The organisations’ performance is measured purely in terms of financialreturns. Other than as benchmarks of performance, the achievements of competitors are notof immediate concern. Yet strategic managers are often more directly concerned withmarket position. A high market share is, generally, regarded as better than a low one. This isnot irrational. Higher market shares are often associated with high absolute profits and betterreturns, an idea encapsulated in many grid methods of strategic analysis such as the BostonConsulting Market share-market growth Grid (Hedley, 1976). In practice, the details of therelationship between market share/position and profitability are complex (Buzzell et al.,1975; Kwoka, 1979; Prescott et al., 1986; Wright et al., 1990; Montgomery and Wernerfelt,1991; Davis et al., 1993). It must be added that higher market positions play to strategists’egos and career prospects.

Position – or ordinal – risk is the risk that a strategic decision might result in a firm losing (orgaining) its ranked position in a market. This idea of ordinal risk has been picked up byCollins and Ruefli (1992) who develop a measure of the uncertainty in an industry sectorbased on the rate at which firms change ranked market share positions. The impact ofderegulation on ordinal risk for the US Airline Industry is evaluated by Ruefli (1988).

6. Risk and the brain

It is now recognised that much decision making is automated and is dependent on cognitivestrategies – heuristics – that simplify decision-making. Such simplification is valuable. Ittends to be quicker and demand less effort than decision-making based on calculation:heuristics are ‘‘fast-and-frugal’’, and so lend themselves to decisiveness. On the other hand,such heuristics often produce decisions that are at odds with what rational methods suggestmight be optimal. Important examples of heuristics that have been found to influencestrategists risk behaviour include anchoring – the use of irrelevant numbers to groundnumerical estimates, availability – using how easily an instance can be recalled as a basisfor judging its probability and representativeness – judging the type or possibility ofsomething on the basis of how well if fits with a preconceived idea (Wickham, 2007b). Thereis growing evidence that these heuristics are hard-wired into the architecture of the brain.

7. Risk and the mind

We often make decisions quite spontaneously and with little conscious mental effort,especially if those decisions are felt to be trivial or routine. Most strategic decisions are quiteexplicit though and strategists are aware that they are making a decision. ‘‘Metacognition’’ –deciding how to decide – may come into play. Risk is generally perceived of as somethingunpleasant. Its presence makes decisions more difficult. As perceived risk increases, moreeffort is likely to be put into choosing options. There may be more hesitancy in actuallymaking a choice and the possibility of avoiding or deferring decisions be taken moreseriously. Kahneman and Tversky (1984) posed a famous problem to decision makers inwhich they had to choose between two vaccination programmes to treat an outbreak of afatal disease. One programme (the ‘‘safe’’) would result in one-third of people being curedfor definite, the other (the ‘‘risky’’) might cure all people but only at a one-third chance. The

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trick was the options were presented in two ways to different groups: in the first, the problemwas posed as people dying or not dying, in the second, as people being saved or not beingsaved. In the ‘‘die’’ version, the sense of loss induced preference for the risky option. In thesecond, the sense of gain encouraged taking the safe option (exactly as Prospect theorypredicts). It was suggested that this is anomalous as both pairs of options are the sameapart from the wording: ‘‘die’’ being the same as ‘‘not-saved’’ and ‘‘not die’’ the same as‘‘saved’’. However, when deciders are asked why they made the decision they do, manyrespond that, ‘‘not-saved’’ is not the same as ‘‘die’’. ‘‘Die’’ is final; ‘‘not-saved – yet’’suggests that some time might be bought to explore other courses of action. This ‘‘framingeffect’’ has been shown to affect managerial decision making. A review is provided by (Levinet al., 1998).

When faced with risk, strategists often feel challenged or uncomfortable with the demand tomake a decision. Emotions come into play and these can affect decision making in a numberof subtle ways (Lerner and Keltner, 2000). Emotions can be classed as positive or negativeand, at the same time, as inducing uncertainty avoidance or seeking. Contentment, forexample, is a positive emotion that leads to a preference for certainty while hope is positiveand leads to preference for uncertainty. Anger is a negative certainty inducing emotion whileanxiety and fear are negative and uncertainty inducing (Lerner and Keltner, 2001).

Framing and emotion impacts not just on certainty seeking or avoidance and the outcome ofthe decision, but also the processes – cognitive and organizational – by which the decisionis made.

8. Sharing risk

Inevitably, our decisions affect others. The decisions made by strategists do not just affecthow resources are distributed to the organisation’s stakeholders, but also how risks areshared. The highly influential ‘‘Balanced Scorecard’’ approach (Kaplan and Norton, 1992;2007) emphasises the extent to which all stakeholders, not just shareholders, have aninterest in, and rights with respect to, an organisation’s performance. Yet even within thisframework the way in which different stakeholders share and accept different risks is notconsidered explicitly. The idea that managers are less able to diversify personal risk thanshareholders can financial risk does feature in some aspects of agency cost theory. This canexplain why managers are more likely to favour value destroying mergers and takeoversthan shareholders. A number of disparities are evident in relation to customers. In transportAirlines usually offer compensation to passengers if flights are delayed or cancelled. Railcompanies rarely do. The pharmaceutical industry is obliged to demonstrate theeffectiveness and safety of their products through expensive clinical trials. The‘‘alternative’’ health products sector is not so required meaning users face the risk ofproducts not working or turning out to be harmful. A lot of negotiation between employersand trade unions is about who takes the risks rather than who gets what resources.

The notion that we live in a society where the conflict between ‘‘capital’’ and ‘‘consumers’’ isone of inequitable risk sharing, rather than resource sharing is taken up by the post-Marxianthinker Ulrich Beck, especially in relation to technological risks. Beck’s Risk Society ideas(Beck, 1992) have been very influential in environmental politics (Mythen, 2004).

Any strategists working in an industry at the edge of technological development will beaware that the public at large (and consequently Government) are both highly reactive toperceived risk and are often not ‘‘rational’’ in that response. By rational it is meant thatpotential benefits and costs (and their chances) are not taken into balanced consideration(Sunstein, 2002). When faced with a new or unknown technology, there is often a call for the‘‘precautionary principle’’ to be brought into play: a demand that the technology be put onhold until it is ‘‘proved’’ to be safe (Morris, 2000). Not only is such proof often difficult toobtain (at least to the satisfaction of those demanding it), it hinders to introduction ofproducts with many potential benefits. Such demands often reflect ‘‘dreads’’ –consequences that are severe (even in unlikely), beyond current experience and overwhich there is little control (Slovic et al., 1979). There may be a reaction to key phrases, forinstance ‘‘nuclear’’, ‘‘genetic’’, that stimulate fears socially amplified by lobby groups andmedia attention (Kasperson et al., 1988).

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Risk: an integrated view

How then is the strategist to understand risk in order to work with and manage it? Should the

economic, psychological, organizational and social approaches to risk be regarded as

talking about quite different things? This would not be helpful. There is enough of a common

theme running through all perspectives on risk – as lack of knowledge, variation in

outcomes, fear of loss, a stimulus to decision making, something that shapes strategic

choice and behaviour and an aspect of the organization’s relationship with the wider world to

maintain an integration in which these different perspectives play distinct and

distinguishable parts. Table I is a check-list of questions the strategist might consider

when evaluating the risk of different strategic options and managing that evaluation within

their organizations.

Table I

Aspect of risk Key questions

Formal What are likely financial (or financially valued) outcomes?What are the chances of these outcomes?In what ways are all strategic options the same?In what ways do they differ?Is the decision one under conditions of risk or ambiguity (how definite are the chances of different outcomes?)?

In conversation How are potential losses emphasised over potential gains?What fears and anxieties do these losses create?How are these being expressed?How are potential gains being allowed to compensate for potential losses?What are the non-monetary outcomes?To what extent are option risks described in qualitative terms?How might qualitative meanings differ between different evaluators?What (if anything) might be gained by shifting to numerical estimations of chances?

Choice How do the options look in absolute terms and relative to some reference point?What are the reference points for the decision (current status/comparator organization performance/future goals)?Are options being described in terms of potential gains or losses? How do the options look if gain and loss framing ischanged?How significant is loss aversion? For whom?Are chances being weighted (especially low chances overvalued and high chances undervalued)?

Behaviour Consider the ‘‘RAWFS’’ heuristic:What attempts are being made to reduce uncertainty?What assumptions are being made when information is missing?How are different options’ pros and cons being weighed (qualitatively or quantitatively/in a balanced or unbalancedway)?Are decisions that involve too much risk being forestalled? How wise is this?Is there suppression of evidence that seems to increase uncertainty? Should a greater effort be made to get thisevidence into consideration?

Position How might the different options (potentially) affect the organization’s position (market/strategic)?

Brain What heuristics might come into play when considering and evaluating the different options (self/others)?

Mind To what extent is the decision seen as routine or non-routine? Problematic or non-problematic?How are different options’ gains and losses framed (in positive or negative terms)?What emotions are the different options generating?Are these positive or negative?How might these induce uncertainty seeking or avoidance?

Stakeholders Who are the key stakeholder groups?What do they currently get (resources)?How certain are they of getting these (risk)?How will different strategic options change what they get (resources)?How will different options change the certainty with which they get them (risk)?How might stakeholders react (changes in resources/changes in risk)?How rational are stakeholders in their understanding of the risks?To what extent do risks present ‘‘dreads’’ (severe consequences; unknown experience; lack of control)?To what extent are these risks (perceptions) currently politicised? How might they be in the future? (PEST factors)

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Corresponding author

Philip A. Wickham can be contacted at: philipwickham@btopenworld.com

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