In order to get back on the path of value-creation and rational, sustainable economic growth, businesses must first tackle their tendency towards absolute risk avoidance and recognise that risk is, necessarily, part of the value generation equation. In this article, the first in a three part series of essays on business risk management, Christopher Surdak discusses the apparent expectation of growth without risk.
Summary
When I was very young, I remember adults telling me a range of sayings about money, value, and working. Usually these sayings would go something like, “You don’t get something for nothing”, or, “Nothing of value is free.” Other favourites of prior generations included, “Waste not, want not”, “You get what you pay for”, or “A penny saved is a penny earned.” These notions of value were ingrained in me from a very young age and they’ve stuck with me, with varying degrees of success, to this day.
While many of us may be familiar with such concepts there seems to be much evidence that people believe the exact opposite of these old axioms. From government handouts to the bailout of entire countries, from corporate quarterly reports to Internal Rate of Return (IRR) hurdles set by financial executives, it seems that we humans have a built-in expectation of getting something for nothing.
The principle of creating value while minimising risk is a long-standing goal of business management. Every potential reward carries with it some related risk of loss and the role of executives, managers and leaders is to balance the risk/reward equation. To meet this expectation business people have been creating a range of tools designed to this end. Financial forecasts, Return on Investment (ROI) analyses, Management By Objectives (MBOs), Key Performance Indicators (KPIs) etc., are all artifacts of the desire to assess and manage the relationship between risk and reward. These tools are so pervasive that they are part of the basic curriculum of business and engineering schools the world-over.
[ms-protect-content id=”9932″]However, throughout business and society there appears to be an expectation of growth WITHOUT risk, which I propose is an impossible and undesirable trend. Over many decades our expanding practice of monitoring every nuance of our business operations and decision-making in an attempt to manage risk appears to have been perverted. There appears to be a growing trend towards risk avoidance rather than merely risk management and this is leading to extremely counter-productive behavior on the part of many businesses.
In order to get back on the path of value-creation and rational, sustainable economic growth I’d offer that businesses must first tackle their tendency towards absolute risk avoidance and recognise that risk is, necessarily, part of the value generation equation.
In this, the first in a three part series of essays on business risk management, I discuss this apparent expectation of growth without risk. I discuss where this expectation comes from, why it appears pervasive in today’s business environment and why this trend may no longer be sustainable.
Part two of this series will present a number of tools, techniques and approaches used by managers to avoid risk, and why this may explain the slow-down of growth in the global economy. Finally, in part three I will discuss how some leaders are more successful at managing risk than others and the tools and techniques they use to achieve their results.
Risks and Rewards: A Primer
A fundamental tension in business, and indeed in life itself, is that between risks and rewards. Whether we are seeking air, water, food, shelter, clothing, companionship, knowledge or principle there is some risk of disappointment and loss with each need we strive to fulfill. This is the basis of choice in life, and is a fundamental struggle that all organisms face each day; what we often refer to as “living.”
This same principle holds true in business. In business we combine limited resources (capital, time and labour) with intangibles (knowledge, innovation, choice and experience) to create desired outputs (more value-added resources, profits or perhaps the most desirable output there is: more time). Collectively we have labeled the process of deciding how to best combine these inputs in an effort to gain these outputs “business,” and the people making these decisions “managers.”
As a mid-career business person I have undergone decades of training in economic and business principles. This training, both formal and informal, has ingrained in me the fundamental concepts of how markets think, how investment works, and how the marriage of capital, labour and innovation foster growth in our global economy. Like you, I have been force fed from the well of knowledge regarding how best to create maximum value from each investment made, while managing factors that introduce variability, instability and ultimately risk into the equations by which businesses operate. But, as you may have seen me express in past essays, as time wears on I grow increasingly skeptical of these teachings, or at least the Modern, Western, Capital-Centric interpretation of them.
Opportunity Costs
In the natural state of our world there is very little that may be gained without some degree of risk. Risk and reward generally scale harmoniously; the greater the potential reward, the greater the risks involved.
Like our ancestors, we face these choices every day. For instance:
1. Eat this apple: If it’s poisonous, you die, if it’s not, you live another few hours.
2. Kill that mastodon: If it succeeds in defending itself, you die; if you kill it, your whole clan lives for a month.
3. Buy oil futures on the commodity markets: If global demand for oil goes one way, you make money, if it goes the other, you’re ruined.
This makes sense because rarely are there rewards to be gained without competition or risks in doing so. Organisms are constantly at odds with each other over limited resources. Where a resource is unlimited organisms naturally grow until it is no longer so. Nature hates a vacuum and life hates an untapped resource. As such, we all live in a universe where, according to the First and Second Laws of Thermodynamics, nothing comes for free; at least not for very long. We will return to this discussion in a moment.
Are we better off if we take this path or that, make this investment or the other? Invariably one choice is better than the others and our ability to make the right choice can at times be the difference between life and death. This opportunity cost is a further dimension of risk. When one combines the process of attempting to optimise opportunity costs, maximise profitability and minimise risks with our present ability to measure ourselves down to exceptional degrees of granularity, strange behaviours start to arise. As physicists found with quantum mechanics, at the scale of the very small and very detailed, our beliefs about how the world works start to fall apart.
Homo Irrationalis?
While risk, reward and opportunity costs are all a part of life, in many ways we humans have been insulated from some of the effects for an extended period of history. Humanity has experienced explosive growth in a relatively short period of time. We launched ourselves out of Africa upwards of 70,000 years ago pushing before us any number of less aggressive, less clever, less irrational cousins who stood in our way. We conquered Europe and Asia in due course and exploited plants, animals and minerals by inventing the technologies now known as agriculture, animal husbandry, mining and engineering.
By 45,000 years ago Australia fell; crossing Asia in a remarkably short period of time. By 14,000 years ago we breached North and South America, pushing before us mega fauna such as mammoths, ground sloths and mastodons and dominating the genetic future of plants such as corn, tomatoes, potatoes and chillies. By 5,000 years ago most of Polynesia was ours too. By then we understood the breadth of our vacuum.
For the next five millennia, it was time to fill it. And fill it we did. From Babylonia to Egypt, from Greece to Rome, from Mongol to Ch’in from Spanish to English, we sought to fill the relative void of unexploited resources. And all along the way, we bred ourselves to be good at it, too.
Filling the Cup Called Earth
Once we had discovered our world we began to infiltrate all of its nooks and crannies. We began to leverage its depth through exploitation. Geographical exploitation resonated with our technical advancement allowing us to use up the planet’s resources with ever-greater efficiency; otherwise known as economic growth. Indeed, the combination of finding new resources to exploit (The Western Hemisphere, for instance) and new technologies with which to exploit them (steel, gunpowder or oil, for instance) directly led to the massive growth in the human population, our economy and our relative wealth.
D.I.E., Discover, Infiltrate, Exploit. This is a process that defined who we are, what we do, and how we do it as a species. It is the basis of our culture, our lives, and our economy. We have used this approach to dominate our planet and to grow fantastically rich. It could be argued that a great deal of this growth was achieved with relatively little risk to us. Certainly, millions of people died at the hands of emperors, slaveholders, conquerors and generals. Still millions more died in the processes of exploration, colonisation, exploitation and industrialisation. And, occasionally some of us succumbed to a random bear, shark, angry bull or tsunami.
Nevertheless the gains achieved over the last few Millennia came relatively cheap. The wilderness that we pushed aside was at times harsh but it never really stood a chance. There were no other species that had a reasonable chance of out-competing us, with the possible exception of various bacteria or viruses. I’m not suggesting that our conquest of our planet was cheap or easy but it certainly wasn’t a fair fight, either. Using DIE, humanity discovers new territories to put to use, infiltrates them to understand them and then exploits them to our advantage.
We leveraged technology more and more and exploited the untapped reserves of our planet seeming to gain accelerating degrees of productivity, and with it profits. Where productivity growth outpaces inflation we experience an interesting result: effectively-free money. That is, each unit of input creates more than what may be reasonably expected in direct conflict with the First and Second Laws of Thermodynamics (which state, in part, you don’t get something for nothing).
DIE, and Expectations of Riskless Rewards
As we took over the planet we were effectively filling an empty cup; we were fighting against nature and chance but little else. Combining our technology with our relentless nature and DIE approach allowed us to succeed with relatively little risk; at least in light of the rewards to be gained. Our success at this process seems to have instilled in us an expectation of riskless rewards. It gave us a belief that we somehow rose above the survival equation that governed all of the other organisms that share our planet. Indeed, many of us believe that we are in fact Divine. Many believe that we don’t follow nature’s laws but rather another set of laws, and a different set of rules. We have developed an expectation of great rewards for relatively little risk because as a species this has been our experience for a quarter of a million years.
This expectation and the power of our DIE approach is evident in our conquering of the New World, where we stripped the continents bare of their trees, tilled their native plants under to create farmland, dammed their rivers, harvested their fauna, and dug up their minerals, all for our use. With industrialisation we further extracted their mineral wealth and put our populations to work in powered factories. Again, there were risks in all of these activities but nowhere was this risk proportional to the gains made by our society; by the wealth CREATED by these activities, in defiance of the laws of thermodynamics.
Pushing the Digital Frontier
During the first half-century of the information age our society has experienced productivity growth that far outstrips anything we have seen before. In information we found a new frontier with which to apply DIE, and we have done so with great vigor. We applied DIE and expected to again make large gains in return for little risk.
Information technology has been used to improve the intangible inputs in our economy; the knowledge, innovation, choice and experience that we apply to physical resources to create value. This, in conjunction with the growing ability to measure our performance with ever-greater precision, seems to have convinced us that risk is not only manageable, it should be avoidable. In so doing, we were creating value from using physical things more efficiently, effectively and creatively, but we still had the same amount of stuff to work with.
Accelerating productivity meant that business people found themselves in an unlikely and unsustainable situation; both the opportunity costs of and the risks associated with any particular investment have been disproportionate and unreasonably small. The harmony between risk and reward has been skewed, although thankfully in our favour. This has been our experience of the world for a very long time and it seems that we expect that these unreasonable gains will continue unimpeded by the laws of nature.
Perhaps this is the key to our current economic climate. In a finite world with finite resources we can become ever more clever in how we use those resources to make outputs that we desire but the world is still finite, and there is only so much that improving our intangibles can do to make up for this situation.
Heisenberg Was Right
As noted previously our society has created a range of tools for assisting in the process of business investing and these have grown in sophistication, resolution and accuracy over the years. Most contemporary managers are drowning in reports, metrics, alerts, warnings and KPIs, all designed to assist in creating value from investments while minimising risk.
As with all things in the universe the process of measuring the relationship between risk and reward changes the relationship itself; an application of Heisenberg’s Uncertainty Principle from Physics. Heisenberg uncovered that in order to measure the state of an electron one had to observe it. But, he noted, the observation could only be made as a result of a change in the electron’s state, which meant that the electron was no longer the same after the observation and the measurement necessarily gave a slightly inaccurate reading.
The same is true in metric-driven businesses. We measure our organisations both more thoroughly and with greater granularity which naturally changes the conditions of the business itself. When we measure that something is wrong, we strive to fix it. When quality is poor we try to improve it. When a process is inefficient we change it. This is learning and growing, and we expect this of both organisms and organisations.
The End of the Road for Easy Money?
Metrics, Information Technology, Analytics, Machine Learning; all of these things are intangible inputs into what makes our society and our economy function. Our technology advancement will no doubt continue apace and we may continue to see humanity’s DIE approach continue to work, at least for a time. While this continues we may still enjoy relatively riskless rewards, and continue to grow inside our limited ecosystem.
However, there is talk these days about our planet running out of carrying capacity for humanity’s activities. That we need to do more discovery of new frontiers, we need to find new resources, we need to find new sources of the stuff of life, and perhaps depend a bit less on infiltration and exploitation. Maybe this means colonising the Moon or asteroids, maybe it means conquering the ocean depths, perhaps it means digging ever deeper into the Earth. In any event, without tapping into new sources of raw materials it will be increasingly difficult to make easy money out of our old friends: infiltration and exploitation.
What Does This Mean for You?
If you’re still reading hopefully you found this discussion to be of some interest. There are powerful parallels between how humanity has taken dominion over our planet and how we operate our businesses today. It may not always seem like it, but many of our businesses operate as if our world is relatively free of risk. We act as if growth rates greater than the rate of inflation are a rule, rather than an exception. We appear to believe that we can get, indeed SHOULD EXPECT, something for nothing.
This thinking may be appropriate during the Discover and Infiltrate phases of humanity’s DIE approach. But this thinking completely falls apart in the late stages of Exploitation. One wonders what was going through the mind of the leader who ordered the death of the last wooly mammoth, or the cutting down of the last tree on Easter Island in the Pacific. What will be going through the mind of the fisherman who lands the last tuna, or the truck driver who hauls the last load of mineable phosphorous, so critical to 21st century agriculture?
Success in business means making good choices regarding risks and rewards. Even so, for most organisms competition means that risks win out more often than not. This hasn’t been the case for humanity in a very, very long time. Instead, we have lived under the graces of a rich planet that has supported, even encouraged, our Discover-Infiltrate-Exploit approach.
In order to succeed going forward it is critical for business people to know in what part of the DIE continuum your business is in, how many resources remain for your continued use, and how much room is left for intangibles to drive further returns on investment. If you are in an old industry, using old technologies, experience, processes and resources to produce the same old outputs, there is likely very little room for further exploitation. As such, your expectations of continued growth without risk are not only misplaced, they’re irrational.
Conversely, if you are discovering new territories, new sources of raw materials (actual or intangible) new worlds to be conquered, you may continue to use humanities tools to full effect. Finding new worlds and new resources is where DIE works best. It is innovators and explorers who are most likely to continue to find new lands from which they can create riskless rewards; or at least the illusion thereof.
In the following two segments of this discussion we will explore the DIE behaviours that demonstrate irrational expectations of riskless returns, and examples of those who have effectively created new territories to be explored, in the face of great risk.
Christopher Surdak is an Engineer, Juris Doctor, Strategist, Tech Evangelist, 2015 Benjamin Franklin Innovator of the Year, and Honored Consultant to the FutureTrek Community, Beijing, China. He is also the author of Data Crush: How the Information Tidal Wave is Driving New Business Opportunities, which is GetAbstract’s International Book of the Year for 2014.
[/ms-protect-content]