Fear of failure can sabotage business leaders

While there is tremendous uncertainty right now, even in stable times, executives tend to overweigh the potential for losses relative to gains. We have been working with companies on making

strategic investment decisions for over 30 years each and we have found consistently executives weigh losses more heavily than gains and pass on opportunities that could be beneficial for

shareholders and other stakeholders. With the increasing instability in the market, executives are likely to become even more wary to take risks of any size.  Advertisement Advertisement In

a 2012 McKinsey survey of 1,500 global executives across many industries, we presented the executives with the following scenario: You are considering making a $10 million investment that

has some chance of returning, in present value, $40 million over three years, with some chance of losing the entire investment in the first year. What is the highest loss you would tolerate

and still proceed with the investment? A risk-neutral executive would be willing to accept a 75% chance of loss and a 25% chance of gain. One-quarter of $40 million is $10 million, which is

the initial investment, so a 25% chance of gain creates an expected risk-neutral value of zero. But most survey respondents demonstrated extreme loss aversion; they were willing to accept

only a 19% chance of loss to make this investment, nowhere near the risk-neutral answer of 75%. In fact, only 9 percent of respondents were willing to accept a 40% or greater chance of loss.

Informally, we’ve asked groups of executives the same question at even lower levels of investment and found similar results. This phenomenon has serious consequences for hierarchical

organizations. Executives are just as loss-averse when the bets are small as they are when the gambles are large, even though small gambles do not raise the same issues of survival or ruin

that provide a rationale for aversion to large risks. What’s more, small gambles offer opportunities for the risk-reducing effects of aggregation. Since many experts predict a recession in

the near future, this only stokes the fear of loss further when the hesitance is high to begin with. Jeff Bezos, founder of Amazon, puts it this way: “I always point out that there are two

different kinds of failure. There’s experimental failure—that’s the kind of failure you should be happy with. And there’s operational failure. We’ve built hundreds of fulfillment centers at

Amazon over the years. ... If we build a new fulfillment center and it’s a disaster, that’s just bad execution. That’s not good failure. But when we are developing a new product or service

or experimenting in some way, and it doesn’t work, that’s okay. That’s great failure.” To overcome loss aversion and make better investment decisions, individuals and organizations must

learn to _frame _choices in the context of the entire company’s success, not the individual project’s performance. In practice, this means looking at projects as a portfolio by aggregating

them, rather than focusing on the risk of individual projects. It might also mean altering incentives for individual executives to overcome the wrong framing of the decision.        That’s

easy in theory, but executives are typically concerned about the risk of their own projects and the potential impact on their careers. That’s why those decisions should be elevated to

executives with a broader portfolio of projects whose risks cancel each other out. Often, the decisions must be pushed up to the CEO.  To be most effective, companies also must encourage

middle-level managers and other employees to propose risky ideas. Companies can do this by eliminating risks to the employee. Many employees censor themselves because of concerns that their

careers will suffer if their idea for a project fails. To overcome this concern, it’s important to agree on the various risks up front with the top leadership and conduct post-mortems on

projects, particularly to identify causes of failure. If a project fails because the decision to go ahead with the project turns out to be incorrect (which should happen frequently), that

failure should not bear on the manager responsible for the project. The responsible manager should only be accountable for the quality of execution of the project.

                                  One technology company successfully used a portfolio approach to assess its projects. First, executives estimated the expected return of each project

proposal (measured as expected present value divided by investment) and the risks associated with each (measured as the standard deviation of projected returns). Executives then built

portfolios of projects and identified combinations that would deliver the best balance between return and risk. When they viewed portfolios of projects in the aggregate, executives could see

that portfolios of projects had higher returns than most of the individual projects and much lower risk compared with most of the individual projects.                            It’s worth

pointing out that even though a portfolio of projects has lower risk, the use of portfolios does not lower a company’s cost of capital. That’s because the portfolio, by definition, cannot

reduce the non-diversifiable risk, which is the risk embedded in the cost of capital. Executives squander good corporate strategy when they lack the courage needed to turn ideas into

value-creating actions. _Excerpted with permission from the publisher, Wiley, from Valuation: Measuring and Managing the Value of Companies by Tim Koller, Marc Goedhart, and David Wessels.

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