Business is, like life, about taking, managing and coping with risk.
Economists categorise a risky activity as having two characteristics:
- The likely outcome, for example the return on an investment; and
- The degree of variation in all possible outcomes.
So, a ‘fair gamble’ is one where, on average you will achieve zero monetary profit. For example, for your investment you have a 50% chance of gaining £100 but you also have a 50% chance of losing £100. On average you do not gain.
An ‘unfair gamble’ means you will have only 30% chance of making that £100 but you have a 70% chance of losing that sum. On average you will lose by accepting such a gamble. This is how most casinos operate where the chance of winning always lies on the side of the house.
You also have ‘favourable gambles’. This is where you have, say, a 70% chance of winning and a 30% chance of losing. Such situations are referred to as profitable. Success in business is about seeking out ‘favourable gambles’.
There are also different levels of risk. So, for your initial stake you have the chance of winning £200, not £100, with the same percentage odds, your bet will be ‘riskier’.
Bear in mind, for most marketing campaigns, you should be looking for a return on investment many times that of your initial stake; your marketing budget. It is not unusual to expect a return on marketing investment of between 500% and 1000%. So you are looking at a ‘bet’, not of 100:30 but of between 1:5 or 1:10.
Businesses, like people, will have different risk profiles. Economists classify such attitudes into these groups:
- Risk averse
- Risk neutral
A risk neutral business will only invest when the outcome is likely to be profitable (on average. They are only interested in fair gambles or better.
A risk averse business will refuse a fair gamble and will only invest when the odds are sufficiently favourable and the potential monetary profit will overcome their inherent dislike of risk.
A risk-loving business will take on an investment even if the strict mathematical calculation of the risk describes the investment as unfavourable.
Think of Richer Sounds, the hi-fi and electronics retailer. The business has been in operation for over forty years and on average has opened one shop every couple of years. The slow careful growth of the firm could easily be described as, at best, risk neutral, and potentially risk averse.
Compare that position to the actions of Fred Goodwin at Royal Bank of Scotland. One of the accusations made of Goodwin on the banks collapse was that he was pursuing rapid growth at all costs. He was making investment and purchase decisions whilst ignoring the normal due diligence analyses carried out by the bank’s staff. This resulted in the disastrous purchase of ABN Ambro, the Dutch bank. In fact that purchase was not of all of ABN Ambro. The profitable retail arm of the bank was purchased by Santander. What Goodwin had purchased for RBS was ABN Ambros’ investment banking arm, which was stuffed full of American sub-prime mortgage debt.
Fred Goodwin was clearly a risk-lover.
Insurance is the opposite of risk.
Insurance is the payment of a small sum to cover unlikely events. So you are willing to invest £300 a year to insure your car which is worth £15,000 (despite the fact that it is a legal requirement).
However in business, often the cost of insurance is ignored. There was much anger that, after the disastrous fire, Glasgow School of Art was not insured. But it is likely that the Charles Rennie MacIntosh designed building was uninsurable as the cost of a policy would exceed the cost of repair or rebuilding the school. So, a business decision was made not to insure the building.
In such circumstances both a risk neutral manager and a risk loving manager would reject the cost of the insurance offer.
So if you cannot buy an insurance product to cover a business investment, how do you protect your investment?
In traditional gambling, a ‘punter’ will spread his bets. He will make a small bet on a horse with long odds and a larger bet on the favourite. If the favourite comes in, he takes his winnings, but if the outsider comes in, he covers his initial stake.
Some professional gamblers tactically ‘bet to lose’. They make smaller bets against favourites. Think how often horses listed as favourite fail to win races.
In the financial markets, investment brokers use hedge funds. They hedge their bets. So if they buy shares or derivatives with the intention of selling at a particular rise in price, they will cover the risk of that growth in value not occurring by laying a ‘hedge’ with a hedge fund to cover their investment.
For most small businesses, there is little opportunity to hedge or to insure investments in things like product development and market entry. So how do you protect your investment.
Well, that is where Philmus Consulting comes in.
Philmus Consulting can help your business develop robust due diligence systems with respect to food standards, metrology and trading standards. We can help you with product safety risk assessment and product recall plans. If you know the risk in a particular regulatory area, you can reduce the chance of the risk occurring and mitigate its effects.
In marketing, risk is reduced through market analysis and marketing research. You reduce risk by using such information to set realistic business goals. You reduce risk by creating strategic marketing plans and by defining alternative opportunities. This can be achieved through the use of tools such as the GE matrix and the Shell Directional policy framework. You reduce and insure against risk by researching your target market and developing products to meet the needs of that target market. This is by far a more preferable route to product development than that of creating a product and then trying to find a market for it.