Level of risk
Every individual, and thus every group, has a certain level of tolerance for risk. For example, there are those of us who are gamblers, and there are those who hate to lose and never go near a slot machine or gaming table. Risk tolerance is usually determined by one’s experience with having taken risks. If you risk and lose, you tend to become risk adverse.
In business, these tolerances for risk come to the surface whenever there is opportunity for new investments or changes in services. The factors to consider when an investment decision must be made include: what is the potential gain from the investment or change, what would it cost to realize it and what is the probability of success.
I have worked with several leadership teams and governing boards of companies that have either come out of bankruptcy or come perilously close to it. In many of these cases, board members are terrified to approve an investment no matter how strong the evidence. They risked before, and it didn’t go as expected. However, this strong aversion to risk can greatly impair the ability of the company to grow.
On several occasions I have worked with boards who have sent their CEOs off looking for new opportunities with a strong directive to “grow the company”. The CEO does extensive due diligence on the opportunities only to find that none of them get approved. Each opportunity seemed to be rejected for different and inconsistent reasons. In those situations, there is a disconnection between the board’s desire to grow and their willingness to take a risk to make it happen. Without the latter, the former won’t happen.
To avoid paralysis, we recommend that leadership develop and adopt a policy on the criteria and standards it will use in considering new investment decisions. The process of getting there forces both the C-suite and especially the board to confront different risk tolerances among themselves and then settle on a policy that everyone can be comfortable with. The dialogue has proven invaluable, and the policy becomes a key tool for guiding management through investment opportunities.
At PGS, we use a Priority Matrix as the tool to implement this policy. Creating a priority matrix involves defining criteria, i.e., what you want your investments to do for you (more on this below), the relative importance of each of these criteria, and then the specific standards for each criterion that are used to score an investment, i.e. what it takes to score a 1,2,3,4 or 5 on a given criterion. Once created, an investment option can be assessed using the priority matrix to determine its viability in relation to the risk tolerance established in policy.
Sample Criteria to Consider
Whether using a tool like the priority matrix or simply creating a policy that addresses risk, we suggest you determine the criteria that are essential to consider before selecting an investment. Criteria can be weighted to show relative importance of one criterion over another. Your organization’s criteria might include:
- Return on investment
- Time until positive cash flow
- Level of risk
- Synergy with other investments
- Ability to execute
- Alignment with vision
- Impact on employee development
- Impact on community
The standards are the basis of comparison between the investment opportunity and the criteria, i.e., how well does an the investment fulfill a particular criterion. The investment is given a score of 1 – 5 based on that assessment. For example, an investment that has a “time to positive cash flow” of less that 6 months might score a 5 on that criteria, while another with a time of over 3 years might score a 2. Therefore, the standards are an essential piece to identifying and clearly defining the organization’s level of risk tolerance
Having clear policy that states the criteria that an investment opportunity must meet helps to clarify the risk tolerance of an organization and provides essential guidance for a CEO to explore and present new opportunities.
If you are interested in learning more regarding policies concerning risk or to receive a sample priority matrix, let us know. We would be happy to get you the information you need to clarify and work with your organization’s risk tolerance.