How to reduce risk, and increase your odds of success

by Bruce Kasanoff on February 27, 2013

“The biggest risk is not taking any risk… in a world that’s changing really quickly, the only strategy that’s guaranteed to fail is not taking risks.” — Mark Zuckerberg, founder of Facebook

These are risky times. The last time the stock market was this volatile was the Great Depression. The last time the economy was this bad was, you guessed it. No one knows what will happen next, and it is crazy to operate your business as though you do.

If only there was a way to reduce risk and still preserve the possibility of big wins.

There is – it’s called the real options approach. Using it, entrepreneurs and managers can lessen the risks they face, even in uncertain times.

According to the book, Real Options, “an option is the opportunity to make a decision after you see how events unfold.”

Make bets after you see what happens, not before.

Think about it. Imagine if you could place a bet on a horse after you see if the horse won. That might be slightly more profitable than betting before the race, wouldn’t it?

The authors explain, “On the decision date, if events have turned out well, you’ll make one decision, but if they have turned out poorly, you’ll make another. This means the payoff to an option is nonlinear — it changes with your decision.”

Why less risk is actually more risky.

Real options theory says the more volatile the times, the more essential it is to preserve a number of options for your company. Thus, taking less risk (preserving fewer options) is actually riskier than investing to preserve a number of options.

Here are some tangible steps you can take to reduce risk and increase your odds of success:

  • Make a list of all investment decisions that are contingent on future events. For example, if orders rise by more than 10%, you will have to lease a new warehouse.
  • Highlight decisions where uncertainty is large enough that you wish to delay an irreversible investment decision, while preserving the option to pursue this course of action. For example, you could rent two temporary storage pods for a month or two while conducting a search for the cheapest possible warehouse space. Neither commits you to a long-term lease, but the latter preserves your option to move quickly if needed.
  • Focus on those investments where uncertainty is large enough to make flexibility important to you.

To give a similar example, instead of committing to build a new building, you could commit to have an architect draw up plans, which will take three months. If at the end of that period you still feel comfortable going ahead with the project, you can use the plans to gain approvals, which will take another six months. But along the way, you are delaying an irreversible decision to approve the entire project.

This is a vastly simplified description of a powerful tool for managing risk and uncertainly. I recommend that you read the book, Real Options.

Previous post:

Next post: