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Overcoming a Bias Against Risk

Economics, Finance, Psychology, biases, investments, risk

Here’s a quick test of your risk appetite. Your investment team has approached you with two variations of the same project: you can either invest $20 million with an expected return of $30 million over three years or you can invest $40 million with an expected return of $100 million over five years (and a bigger dip in earnings in the early years). In each case, the likelihood that the project will fail and yield nothing is the same. Which would you choose?

Much of the commentary about behavioral economics and its applications to managerial practice, including our own, warns against overconfidence—that biases in human behavior might lead managers to overstate the likelihood of a project’s success and minimize its downside. Such biases were certainly much debated during the financial crisis.

Often overlooked are the countervailing behavioral forces—amplified by the way companies structure their reward systems—that lead managers to become risk averse or unwilling to tolerate uncertainty even when a project’s potential earnings are far larger than its potential losses. In fact, the scenario above is based on the experience of a senior executive in a global high-tech company who ultimately chose the smaller investment with the lower up-front cost. That variation of the project would allow him to meet his earnings goals, and even though the amount of additional risk in the second variation was small—and more than offset by a five-fold increase in the net present value—it still outweighed the potential rewards to him.

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