Our Principle Based Management™ framework is rooted in proven principles that have fueled the ongoing success of Stand Together and our partners. Many of these principles are highlighted throughout the Principle Based Management booklet. Over the next few posts, we’ll explore some of these principles in greater depth.
Risk and reward are an inseparable reality of operating any organization. But not all risks are equal. Before pursuing opportunities, we need to analyze the potential risks and rewards and then determine whether to absorb, mitigate or avoid those risks. As nonprofit leaders, our goal should be to make decisions involving risk in a manner consistent with our principles. This includes eliminating catastrophic risks – like those that could lead to a potential loss of life – and optimizing other risks.
Financial investments are a prime example of how an organization may be able to optimize risk. An organization typically has resources that enable it to undertake far greater financial risks than someone might personally take. Suppose you have two opportunities that require the same investment. One has a 90 percent chance of making $100,000 and 10 percent chance of making nothing. The other has a 50 percent chance of making $1 million and a 50 percent chance of making nothing. On a risk-adjusted basis, the expected value of the first opportunity is $90,000 and the second is $500,000; therefore, you should pursue the second opportunity. Although you only get a positive result for the organization 50 percent of the time, it is the right decision. While it may be natural to settle for the safer alternative, doing so can limit your organization’s impact in the long-term.
Facing Decision-Making Challenges
One challenge you might face in motivating good decision making as it relates to risk is the principal/agent problem. This can happen whenever a principal (owner) hires an agent (employee, consultant, etc.). The principal wants the agent to act in the best interest of the principal, while the agent usually wants what is best for the agent. Consider what can happen when the principal and the agent have different risk profiles or incentives. Sometimes agents play it safe because there is no personal upside to taking appropriate risks. Incentives discourage prudent risk-taking when they fail to reward optimal outcomes and excessively penalize losses. Conversely, agents may take unauthorized or imprudent risks when there is not much personal downside. In such situations, agents “go for broke.” Entire companies have been destroyed as a result of this problem. Even so, we don’t want to create a rule-based, overly cautious culture. Instead, we should align the interests of all employees and agents so they will make decisions that maximize the long-term success of the organization.
How To Implement Good Risk-Adjusted Decision Making
Good risk-adjusted decision making also involves avoiding various decision traps. These common failings in judgment affect us all. One of the most serious and frequent is confirmation bias, which occurs when we preferentially look for evidence that supports what we want to believe and ignore or discount evidence to the contrary. Below are ways you can help your organization avoid decision traps and appropriately address risks in decision-making:
- Build a strong culture and invest in the capabilities needed to avoid catastrophic risks and minimize disruptions (stewardship).
- Engage others with diverse experience to challenge your assumptions.
- Ensure employees are equipped to apply your organization’s risk philosophy to decision-making, not their own.
- Develop realistic scenarios for a wide range of potential outcomes, understanding it’s impossible to perfectly predict the future.
- Establish measurements to monitor progress and create options so necessary adjustments can be made.
- Experiment on an appropriate scale rather than diving in without proper analysis (plunging).
- Don’t let prior losses or a leader’s initial rejection prevent consideration of a good opportunity.
- Recognize the uncertainty in your investment assumptions, which are greatest for those farthest out.
It’s important to keep in mind that risk and reward is only one criteria for evaluating opportunities. We must continue to apply our principle-based framework to ensure that we have the capabilities to make an opportunity successful long-term.