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1 October 2009 • 7:00 am

Risky Business

coin_flipAs promised a couple of weeks ago, I’ve now gotten a copy of Sam L. Savage’s The Flaw of Averages from my local library. Although I am still reading it, I can already say that it is an enjoyable read, accessible, and contains a wealth of valuable insights that I’ll be sharing with you. I’ll be buying my own copy soon, and encourage you to take a look at it as well. It has already gotten me thinking more about how much better we need to understand the concept of risk.

We have all grown up in an era in which computing technology has had an increasing influence on the way we think about pretty much everything. In my first year of high school, slide rules were required for those taking physics classes. By the time I took the physics class (in my senior year), we were able to instead share the one calculator the school had bought for each classroom in the physics department. I suspect that some of today’s technologies will someday be as outdated as slide rules are today. If you don’t even know what a slide rule is, don’t worry (but you can read more about it here).

One of the ways in which we’ve been influenced is our tendency to represent uncertainty as single numbers. If you’re filling out a form in which you’re asked to estimate your household income for next year, you likely wouldn’t be able to enter anything but a single number. But a single number simply can’t capture any of the uncertainty of the estimate. To try to help most people understand even the most basic concepts of statistics is an extreme challenge. One cell in a spreadsheet only holds one number.

If you don't know what this is, don't worry.

If you don't know what this is, don't worry.

The concepts of “uncertainty” and “risk” are so poorly understood in organizational settings that they may even be used interchangably. As a result, conversations about risk are difficult, because people understand the concept of risk in different ways. As I hope to cover in the coming weeks and months, one of our biggest challenges today is to introduce the concepts of risk and uncertainty into the strategic planning process. But thanks to Professor Savage, we can enhance our understanding with some plain language examples.

Uncertainty is simply the state of not being able to know an outcome. We don’t know for certain about the outcome of a coin flip, a dice roll, or tomorrow’s stock market performance. By contrast, risk is the probability of a loss or injury.

Suppose I offer you either $100 or nothing based only on the outcome of an uncertain event, a coin flip. Heads, you win, tails you get nothing. But I also offer you a choice; to skip the coin toss in exchange for a guaranteed $30. What would you do?

Of course, the average result of the coin flip is $50, but we’re only going to flip the coin once. So this average outcome (the expected value for those with a statistics background) is a bit of a red herring here. If you’re poor and looking for your next meal, you’d probably take the sure $30. But you might otherwise be willing to accept the risk of getting nothing in exchange for the possibility of $100.

Now imagine the same offer, but instead, the offer is $1 million riding on the coin flip, with an alternative of a sure $300,000. I suspect that you would take the sure $300,000. Unless you’re as wealthy as Bill Gates.

Uncertainty is unavoidable – it is a feature of the universe we live in. No one knows how the coin will flip. Risk is in the eye of the beholder, and a reflection of the impact of the loss or injury to an individual or group. Giving up a sure $300,000 in exchange for an uncertain outcome means something different to you or me than to Bill Gates. Our attitudes towards risk (utility, if you’ve taken the economics class) is different.

Every assumption and decision that goes into the strategic planning process has a degree of uncertainty, and (typically) a level of risk that is poorly understood. By improving our understanding of risk and our attitude toward risk, we can improve the quality and outcome of our strategic decisions. More to come.

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