Risk/Reward Analysis Doesn’t Work The Way You Think It Does

People Often Ignore The Hidden Dimension Of Time

By David Grace (www.DavidGraceAuthor.com)

Almost all human decisions except random choice are based on some level of Risk/Reward analysis.

Most people think Risk/Reward analysis consists of only two factors: the potential risk versus the potential reward.

But that’s wrong.

The Four Factors That Actually Comprise Risk/Reward Analysis

There are four major aspects to every risk/reward analysis:

1) Whose Risks & Whose Rewards? The composition of the group (the Affected Group) whose costs and benefits the decider will factor into his/her decision.

From the decider’s point of view whose benefits and whose losses will be considered in making the decision? Who is in the Affected Group? Just the decider? The decider and his wife and children? The decider and his company? Just the decider’s company and not the decider personally?

2) Over What Time Period? The time frame over which the decider will calculate the probable risks and rewards. A day. A quarter? A year? Ten years?

3) What Are The Expected Losses? The decider’s determination of the identities of and the magnitude of the perceived risks times the probability of each risk impacting a member of the Affected Group during the chosen time frame;

4) What Are The Expected Rewards? The decider’s determination of the identities of and the magnitude of each perceived reward times the probability of each reward being received by a member of the Affected Group during the chosen time frame.

When Risk/Reward Analysis Returns A Bad Result

Many bad decisions do not arise from failing to accurately anticipate the risks or accurately calculate the rewards but rather from picking too short or too long a time frame over which the risks and the rewards will be calculated and/or picking too wide or too narrow a group of people whose gains and losses will be taken into account.

Consider this situation: A heroin addict is beginning to feel the effects of withdrawal. He needs $100 to buy drugs. Should he rob the mini-mart?

Most people would say: “No, because the risk of months or years in jail is high and the reward of one or two hundred dollars is low.” But that opinion is based on the “normal person’s” implicit risk/reward time frame of one or two years.

What is the heroin addict’s risk/reward time frame? One day.

What is his Affected Group? Only himself.

He does not consider either risks or rewards that he may encounter five or ten or 300 days after the robbery nor does he consider risks or rewards to the clerk, the store owner or innocent bystanders.

He only asks himself, “If I rob the store what is the risk of loss only to me within the next twenty-four hours?” His answer: “Low.”

Then he asks, “If I rob the store what is the potential benefit to me over the next 24 hours?” His answer, “I will not suffer withdrawal and I will be able to get high again.”

The addict’s risk/reward analysis correctly determines that over the next 24 hours the reward only to himself from robbing the mini-mart substantially exceeds the 24 hour risk only to himself of robbing the mini-mart, so he decides to rob the store.

You could say that the addict is stupid for picking an overly short time frame but you cannot say that he failed to perform a risk/reward analysis that was accurate for the time frame he selected. Given his one-day time frame he came up with the right answer.

His mistake was not that he failed to perform a risk/reward analysis but rather that he picked a foolishly short time frame within which to compute the risks and rewards and also that he picked an unreasonably small Affected Group.

This is not an isolated event. These short-range, self-centered risk/reward analyses are common and often result in damaging, even catastrophic, decisions at all levels of society from single individuals to huge multi-national corporations and governments — consider the Vietnam War.

Examples Of Risk/Reward Decisions That Yield “Bad” Results In A Business Context

(1) A plant manager who receives an annual bonus based on bottom-line numbers uses a time horizon of less than twelve months. When faced with the question of whether or not to spend $20M to upgrade his deteriorating facility he will balance the risk that not spending the money will cause the plant to fail in the next twelve months (low) against the loss of his bonus if he spends the $20M to bring it up to top condition (high).

Using the 12 month time horizon and only considering benefits and losses to himself personally he determines that the work should not be done, that during the next twelve months the benefits only to himself personally of doing nothing far outweigh the loss he is personally likely to suffer within the next twelve months if he spends the money.

Four years later (after he has retired) the old equipment explodes costing the company $1B in losses and fines. The manager’s risk/reward analysis was not concerned with events beyond the one-year time frame. Consider this in connection with what happened on several occasions at BP facilities in the USA.

(2) The loan manager at a major bank is paid a quarterly bonus. His risk/reward time frame is three to six months. He elects to approve the lending of hundreds of millions of dollars to unqualified borrowers. Eventually, most of the loans go bad and the bank goes bankrupt.

He personally profited over each six month decision period. Because his analysis was not concerned with the risks beyond his six-month time horizon his actions were understandable. Consider this in connection with World Savings and Bear Stearns.

(3) The executives/shareholders at a medical compounding laboratory have a risk/reward time horizon of under twelve months and their Affected Group is limited to themselves. Their analysis showed that within that limited time interval the rewards to the major shareholders from not instituting a strenuous policy of care and cleanliness exceeded the 12 month risks of not doing so.

Over a three year time horizon dozens of people died and hundreds were sickened and the company went bankrupt.

Why Some Valid Risk/Reward Analyses Yield Bad Results

Every day personal and business decisions that eventually cause vast loss and harm are consciously made by people who will benefit from those decisions in the short term.

In all of the above examples:

(1) the risk/reward decisions were correctly made given the time frame and the Affected Group that the deciders picked;

(2) vast loss, pain, damage and harm occurred, sometimes to the deciders and always to persons outside the Affected Groups after the chosen time horizons had expired;

(3) reasonable, intelligent people would say that because of the damages and losses that ultimately resulted that the decisions were “wrong” or “stupid” but all of those decisions were the result of correctly-performed risk/reward analyses given the time frames used by the deciders and given the limited scope of the Affected Groups.

Short-term, narrow-scope choices often lead to decisions that are damaging, wasteful, expensive and inefficient, that is, bad decisions, a result that is inherent in any system involving human beings.

Risk/Reward Analysis Does Not Eliminate The Need For Regulation

Libertarians and anarchists hold it as an article of faith that government commercial regulations are not needed because the fear of adverse market consequences and the seller’s financial self-interest will keep almost all sellers from abusive or dangerous business practices — that insurance companies will pay all legitimate claims, that food producers will distribute healthy and untainted products, that manufacturers will supply safe, nondefective goods because to do otherwise would cost them money and harm the company.

That is a false claim because, among other reasons:

(1) For personal or emotional reasons (stupidity, ego, anger, spite, fear, insecurity, rage, revenge, self-interest, etc.) the decider may well pick a time frame that is too short to yield effective, efficient, profitable or beneficial results over the period of a few years;

(2) Economic factors unique to the decider-executive may cause the decider to pick a time frame that is too short to yield generally effective, efficient, profitable and beneficial results over the period of a few years no matter what the eventual consequences to the company employing him/her may be;

(3) The decider may pick an unreasonably narrow Affected Group (himself and his other insiders) which results in decisions that, while benefiting the members of the Affected Group, wreck havoc on large numbers of people outside the Affected Group and eventually on the company itself;

(4) The decider may mis-estimate the nature, scope, severity or probability of the risks and/or rewards occurring within the chosen time frame to the members of the Affected Group.

The chosen time frame and the chosen Affected Group are almost always influenced by the deciders’ ever-present human factors of greed, impatience, narrow self-interest, fear, anger, ego, personality, and short-term financial incentives.

Why Risk/Reward Analysis Does Not Guarantee Good Results For Businesses, Their Customers, or The Public

Business decisions are based on the evaluation of risk and reward over a specific time frame for a specific Affected Group and the company’s eventual financial losses beyond the chosen time frame neither preclude nor discourage defective and dangerous products or abusive terms of service or dishonest business practices. Unregulated sellers often can and often do wreck vast harm on their customers and members of the public and eventually to the company itself (Enron, Arthur Anderson, Lehman Brothers, etc.)

If emotional, personality or short-term incentive factors cause the decider to pick a time frame that is too short the resulting risk/reward-driven decision may well be an inefficient, wasteful and damaging choice. If through self-interest the decider picks an unreasonably narrow Affected Group then the decision will often be inefficient, wasteful and damaging to the company’s customers and, eventually, to the company itself.

Because of the human factors that affect the deciders’ time horizons and choice of Affected Groups, unregulated sellers often deliver damaging, wasteful, dangerous and abusive products and services, and the fantasy that fear of the Market alone will stop them without the need for government regulation is just that, a fantasy.

–David Grace (www.DavidGraceAuthor.com)