The slope of the boundaries reflects a trade-off between the two kinds of risk. In some cases, the significance of industry risk may be much greater than of country risk, in other cases the ranking may be reversed.
One enterprise may be relatively intolerant of the risk in a particular country although it has expertise in the relevant industry. Another may be happy with the country location, but be operating in an industry which is a fast changing one.
The critical risk levels for the purpose of this book are not those at which generic risk arises, but the enterprise and project levels. Since an enterprise is unique in its various identifying features – resources, struc- ture, strategy, personnel and history, and has a set of capabilities or competencies which include the control of risk specific to the enter- prise, the higher level risk is filtered to the enterprise in a unique way through relevant control responses. There is therefore what might be called vertical overlapping between the risk levels. There is also hori- zontal overlapping in that different shocks may bunch because of some causative connection. Natural catastrophes are often linked with war.
Economic risk is a source of political risk. The nature of risk at these different levels is discussed in chapters 4, 5, 6 and 7.
The potential impact of particular events is described as the risk exposure. This is the extent to which external contingencies threaten the value of the enterprise (Miller 1998: 497, 499). Such an impact reflects the nature and value of the assets affected. In order to specify exactly what value is at risk, it is necessary to specify both the proba- bility distribution of relevant events, including any skewness or kurto- sis of the distribution, and the assets or income streams at risk. The confidence level selected to help determine the value at risk reflects an important third element, the risk appetite.
across-situation consistency, and the degree to which there are group norms, for example how far investors from one country share a com- mon risk appetite. Groups of decision makers in different countries can see the same environment in a different way Hofstede 1991.
Uncertainty acceptance and uncertainty avoidance are one of the five scales by which Hofstede identified cultural differences between soci- eties, indicating the significant degree to which risk tolerance differs from country to country.
All decision makers are often assumed to be risk or loss averse, having a limited appetite for risk. The proposition of diminishing marginal utility of income provides the underpinning for the general existence of such a risk aversion. The rate of diminution may differ from individual to individual, and for decision makers from enter- prise to enterprise. There may also be stretches of income where marginal utility does not decline, in particular there may be very different attitudes to a loss and to a gain.
It is common to conceptualise this risk aversion as one reason for the existence of a risk premium, to be added to the target return which is expected of a particular project. The more risk averse the enterprise, the greater the risk premium demanded. Such a sensitivity to risk can vary over time and therefore imply a changing risk premium. For example, there is evidence that decision makers became more risk averse after the terror attacks of September 2001 (Fan 2004; White and Fan 2004). Another source of a risk premium is the riskiness of the risk environment, tempered by the degree of exposure of the relevant enterprise. It is usually assumed that the more risky the environment, the greater the risk premium demanded of a relevant project. The riski- ness of the environment and risk tolerance are implicitly linked. It is not always possible to distinguish the influence of the two. Effective risk management requires the taking of an explicit attitude to risk and the careful consideration of the actual riskiness of possible outcomes.
The risk appetite reflects six main elements which differentiate the attitude of key decision makers to risk.
• the personality and motivation of the strategists interacting in the decision-making process. Some individuals are more risk averse than others. By definition entrepreneurs have a greater appetite for risk than the average. In reality, few decision makers can afford to be deliberate risk takers. Even the most adventurous seek to control risk. Some are stimulated by the challenge of overcoming risk but always seek to control the level of risk to which they are exposed.
Risk and Risk-generating Events 35
The perception of possible performance outcomes is coloured by the position of the observer and reflects the confidence with which expec- tations of the future are held by that observer. A single dominant per- sonality, the leader or dominant entrepreneur, can be the critical input in the willing acceptance of risky projects. Without a champion with a belief in a successful outcome the project is never undertaken. It is often the role of the leader or entrepreneur to provide such confidence.
Risk aversion often reflects the past history of such an individual.
Recent catastrophic events can have two opposed outcomes: they tend to reduce the appetite for risk and increase risk aversion, or they induce a mood of desperation in which dramatic risks are acceptable.
• ignorance of or unfamiliarity with the relevant area of risk.
The degree of risk aversion might vary according to lack of relevant experience or knowledge, for example, of a particular country. Some commentators believe that decision makers equate risk with difference and that previous experience dictates how far it is possible to live with and control the level of relevant risk. For example Brouthers writes,
‘….as the differences between countries becomes greater on the items being measured, the perception of risk increases’ (Brouthers 1995: 22).
Familiarity may reduce the degree of risk aversion. Certain decision makers may be more sensitive to particular types or components of risk than others, particularly those to which they have not been previously exposed.
• the economic health of the enterprise.
The more vulnerable the enterprise in which the decisions are made, the greater the reluctance to accept risk. Vulnerability may be a matter of:
• chronically low profits,
• persistent loss making,
• high leverage or gearing (how much debt there is relative to equity),
• an illiquid position: low financial reserves and poor borrowing ability.
An enterprise which has few reserves to tide it over during unexpect- edly bad times is bound to be more sensitive to risk than an enterprise which has ample reserves which can tide it over anything but the most
extreme of events. There are various such reserves, from cash held to assets which can be easily realised on the market or used as collateral for a loan.
• the culture of the enterprise.
Corporate culture almost invariably involves an easily identifiable atti- tude to risk and risk taking. A corporate, just as a national culture, can encourage or discourage risk taking. Whatever the views of a single powerful CEO, such a person needs support; an appropriate corporate culture helps. The culture of an enterprise is partly the result of past behaviour and its outcomes – what succeeded in the past and what failed, and partly the result of the attitude and influence of leaders, both past and present.
• the ‘political’ interaction between key decision makers.
Risky projects usually require for success a careful alignment of all the relevant stakeholder groups and an integration of all functional areas.
Conflict can either be channelled into positive attitudes to risk or prevent decisive action and encourage risk-averse behaviour. Fear of a mistake can increase in a context of conflict. Different interest groups clash and prevent decisive action. As a result the whole process of decision making may become much slower. It also becomes a matter of unstable compromises. Sometimes these tendencies are built into organisational structures. The matrix organisation has been particularly vulnerable to paralysis of such a kind (White 2004).
• the ‘framing’ of decisions.
A critical issue is how decisions are presented to the decision makers.
The same problem or decision can be presented in different ways and elicit responses which appear to reveal very different degrees of risk aversion. One well known theory is prospect theory developed by Tversky and Kahneman (1974, 1981) which argues that decision makers evaluate risky options through a subjective value system char- acterised by a reference point such as the status quo or the aspirations that individuals have relative to that status quo. An individual’s esti- mate of the psychological value of an option differs systematically from the actual value of that option according to the reference point used for evaluation. Individuals frame the situation in terms of gains or Risk and Risk-generating Events 37
losses relative to that situation, but can shift their reference points, that is have adaptive aspirations.
Individuals are also loss averse, that is relative to the reference point they weigh a unit of loss more highly than a unit of gain, i.e. they are faced with a S-shaped value function, which is concave for gains and convex for losses. This is the opposite of the function shape assumed by Friedman and Savage (1948) in order to explain why the same individuals simultaneously insure and gamble. According to prospect theory, if the outcome is framed in positive terms, the individual is much more likely to be risk averse; if it is framed in negative terms he/she is likely to be risk seeking. Empirical studies support this, sug- gesting the view that losses are weighted about twice as much as gains.
The problem is to identify the relevant frame for the important deci- sion makers. There is evidence that managers tend to take less risks when their companies are performing well. Troubled firms take more risks. Such behaviour can lead to virtuous and vicious circles and is reinforced by high debt leverage when managers acting for themselves and/or for owners may take more risks, because they enjoy all the pos- sible gains from the upside but pass much of the downside losses on to creditors.
In the context of the investment decision, the general relationship may hold but there is also a specific one. Where opportunity domi- nates threat – the gain domain, a risk-averse approach may be adopted by individual decision makers. Where threat dominates opportunity – a loss domain, a risk-seeking approach may be adopted. However quan- titative is the approach to decision making there is often considerable uncertainty about future revenue and cost streams and considerable discretion in the choice of the numbers to be put into the investment appraisal. The positive or negative framing of decision scenarios is important because the same situation can be described as either a gain or a loss position and can give rise to different estimates.
It has also been argued that individuals adopt little tricks (heuristic devices) which produce systematic biases into decision making. They overweight available information, are ambiguity averse and have an optimistic bias. They do not know how to deal with events with a very low probability and therefore also have a central bias.
Reactions to a particular situation are therefore based on an interac- tion between the attitude to risk and the actual riskiness of a particular project. The risk matrix diagram described earlier is without usefulness if it only records some measure of the riskiness of the relevant envi- ronments. It needs also to display risk aversion. This can be done by
dividing the matrix into three different zones – a zone of acceptable risk levels, one of unacceptable levels and one which is uncertain. The location of the boundaries between these zones indicates the degree of risk aversion. The closer is the situation to the zero corner, the greater is the degree of risk aversion. The breadth of the zone of uncertainty may reflect a lack of familiarity with either country or industry risk rather than aversion as such. It is better, if possible, to separate the risk- iness of an environment from the perception of that environment which reflects the degree of risk tolerance.