Balancing reward and risk to make better decisions
Organizations and their employees are involved in making numerous decisions daily. Some are major, such as deciding on strategy or whether to purchase a new system, while many are small, such as whether to take the stairs or elevator, or where to place your coffee on your desk.
The aggregate outcome of all of these decisions is what determines the success or failure of the organization.
Making better, more-informed decisions, must therefore optimize the value of the organization. We can attempt to program machines to make decisions, but the quality of that decision-making is still dependent on the logic programmed by a human. Humans make decisions in more complex and, often, less logical ways.
Much is written on human decision-making, covering the drivers of things such as emotion, fear, perception, and anchored thinking. I will not focus on these but instead focus on the more logical elements of reward and risk that should be factored into all good decisions.
Optimal decisions involve maximizing the reward (reward is taken to mean net reward—being the net of both positive and negative impact) from the decision over the period that the decision impacts the organization (its life).
To better understand this, we need to:
- Define what we mean by reward
- Determine how reward is affected over the whole of life of the decision and how we can measure reward
- Determine how we can assess whole of life reward at the beginning of the decision’s life.
What is reward?
Reward should be measured against the objectives that the decision is aiming to achieve. This may include financial and non-financial, such as customer service/satisfaction, environmental, social, employee well-being, and so on.
This gives rise to the first difficulty: how do we measure non-financial reward? The accounting profession has struggled with this and, as a result, has focused primarily on financial reward.
More recently, developments in integrated reporting have tried to address this by considering non-financial impacts of an organization as well as financial.
Until we become more capable of measuring non-financial impacts, we must do our best with what we have, which is a combination of quantitative and qualitative measures.
The second issue is determining how reward is affected over the life of a decision. We can split the reward of a decision into three parts.
- Known reward: This is the income and expense that is known with reasonable certainty. When purchasing a new machine, this would include the capital cost and any known servicing costs, etc.
- Estimated reward: This is the estimated future expense and income, which is not certain. This would include revenue generated from the machine and related running costs that would be dependent on output volume. We usually estimate this using a budget.
- The impact of uncertainty on reward: This is the effect of future potential events that are not known with certainty and could have an impact on the budgeted reward. This would include unscheduled outages, unforeseen breakages, and other factors affecting the machine such as power failure, fire, etc. These are our risks. Measuring the risk is not easy. Conceptually, we need to consider the range of risks in the decision, assess their probability and impact, and apply probability theory and discounting to give a net present value of risk.
We then need to aggregate three parts to determine a whole of life reward to decide whether the decision is worthwhile and/or optimal.
We generally refer to items 1 and 2 above as “reward” and item 3 as “risk.” Whole of life decision-making is therefore more commonly known as risk/reward decision-making. This brings us to determining how best we can make risk/reward decisions.
The simplest view is to consider the reward and risk of a decision and apply the following steps:
Step 1: Assess whether the risk is within the organization’s risk appetite. This requires a well-articulated risk appetite that can be applied to the measurement of the risk in a particular decision. If it is not within appetite, we should not proceed further (or we may consider asking the board for a larger risk appetite). If the decision’s risk is within appetite, we should progress to step 2.
Step 2: Compare the reward against the risk. Where the reward is greater than the risk, do it! Where the reward is less than the risk, do not do it! Where you are comparing alternatives, select the alternative that has the highest reward to risk.
- Example: Consider the decision as to whether to maintain one of your current IT systems for the next 5 years or invest in a new system. The old system needs substantial maintenance and is fragile—meaning that there is substantial risk of outages and failure. The new system requires much less maintenance and is more robust and less likely to fail or have outages. We will assume that the output of each system is the same, so we then do not need to assess income, only expense.
A comparison using only known capital and operating cost would favor continuing with the existing system. Taking into account risk, the decision changes in favor of the new system.
Practical steps for you to improve your decision-making
Given that the process set out above is far from exact and that we have a long way to go to be able to quantify all risk in a robust manner, what steps can you take now to move to better decision-making? We would suggest the following:
- Ensure that risk is considered before a decision is made, not as an afterthought.
- Develop a well-articulated risk appetite statement at the board level and cascade this through the organization to allow it be used in step 1 of decision-making to compare the risk against appetite.
- Get better at identifying, recording, and assessing all risks in your decisions and strategy.
- Articulate the size of risk better using quantitative and qualitative measures.
- Educate your decision-makers to ensure they assess risk and reward (whole of life) when making decisions, and make decisions on a rational rather than emotional basis.
Last week I did a webinar for NSW Business Chamber about this topic. I invite you to play the recording here.