Common Sense Rules
Since we live events, not distributions or probabilities, applying some common sense rules will enable us first to survive, and second, to survive on favorable terms.
Identify All Sources of Risk1
Turn over every rock to unearth factors that may influence the outcome of the contemplated course of action. Sources of risk fall into major categories:
Inherent in the project: For example, the ability to complete a project as anticipated, the outcome of events related to pursuit of the project, whether the oil is there or not, and technical issues.
External to the project: For example, political and market factors that will influence the realization of the project and/or the benefits it brings. External factors may influence whether the project proceeds as planned (denied permits, blocked access, nonavailability of materials) and/or the realization of expected benefits even if the project itself is brought to completion as expected (changes in energy prices or taxation, expropriation, etc.).
External–inherent effects: Forces external to the project may affect the course of the project or its outcome. A rise in the cost of ingredients used in a food processing/marketing venture with consequent effects on markets and margins is an example.
Inherent–external effects: For example, the outcome of a project may alter the external environment, as when a project changes the efficiency and economics of microchip manufacturing, with a major impact on applications and markets.
Never Bear Risk Unintentionally
Under the right circumstances the conscious bearing of risk offers opportunity. Having a source of risk that “surprises” us offers the prospect of various outcomes ranging from good, through unfavorable, to bad—perhaps uncontrollably bad or even disastrous.
Remember that risk allows the possibility of good as well as bad outcomes. An outcome that stems from the unconscious bearing of risk might offer an incredibly good reward. Recognizing the possibility of good/bad outcomes is quite different from doing well accidentally. Unfortunately, danger lurks in bearing risk unconsciously—we do not get to choose if the outcome is good or bad. Absent an awareness of the risk, unless we have succeeded in getting another party to bear all known and unknown risks, the impact of unfavorable consequences falls on us.
Overlooking or inadvertently ignoring certain risks can have a disastrous impact on outcomes. A recent disclosure suggests that a major manufacturer of aircraft may have failed to consider consciously the risks attendant on signing sales contracts denominated in one currency while having significant exposure on the input and production side in another currency. Importantly, the choice to accept such risk is logical and defensible even if the subsequent chain of events proves unattractive. To overlook risk when making decisions differs considerably from the choice to accept a risk.
Choose, Rather than Be Compelled, to Bear Risk
Historically, the decision to assume risk, coupled with the events that transpired, has resulted in some very beneficial outcomes. In risk exposure, the issue is choice rather than the level of risk. We purposely offer an example from outside economics. In 1928, a daring surgeon and a patient—the true equity in the venture—took a huge risk when the surgeon performed the first hemispherectomy on a human.2 Individuals have taken extraordinary risks in many fields and under many circumstances so that others might benefit, and we later accord them accolades or see them as an intrepid explorer or hero.
Consciously deciding to bear a risk if there is sufficient potential benefit is logical. Inadvertently bearing risk due to a lack of diligence fails the test of judgment.
Returning to the arena of business, recognizing and accepting the risk inherent in exposure to multiple currencies differs considerably from discovering later that one failed to consider the risks and potential consequences of bearing this risk.
Only Take On Risk You Can Afford to Bear
Regardless of the expected return, bear risk only if the consequences of an adverse outcome are tolerable.
Common sense argues that we avoid risks with potential outcomes that to us are unacceptable given circumstances. Consciously accepting the risk of bankruptcy and ruin to oneself is acceptable. Indeed, a personal choice “to pursue the dream” in the face of huge risk has played an important role in the world, and it will always do so. To lose your own mind capital, or financial or physical capital, or even your life by electing exposure to certain risks seems defensible—and the world has benefited from such risk-takers.
In contrast, exposing others to a risk who cannot tolerate that risk or its potentially catastrophic outcome fails the test of common sense. More importantly, exposing others to risk they do not knowingly choose to bear fails the test of decency and morality.
Clearly Understand Who Is Bearing Risk
Knowledge of the origins and nature of the elements of risk is essential to follow this rule. Whatever the risk at a point in time for a particular project, someone is bearing the risk—either singly or divided in some fashion amongst more than one party. To illustrate, a company may feel it should not bear the collective risks of several projects during a particular time window or during certain phases of the projects. Consequently, the company may share this risk with other parties, with this shedding of the risks either permanent or transitory.
Protect Against the Reversion of Risk
If you intend to transfer risk to another party, ensure that the transfer in fact occurs. Second, protect yourself against the possibility that the risk will revert to you without your permission, or if it does, without compensation. In addition, you must assess that the party accepting the risk can tolerate/survive the risk, and also not escape the risk in a manner that transfers it back to you.3
The burdens of responsibility extend beyond legality. If the risk effectively reverts back to you and you accept the consequences because of your sense of social responsibility, or moral stance, or to protect your reputation, then we commend you. Rather than become the risk-bearer of last resort, instead carefully transfer the risk to those that can and will bear the risk. After all, a default on the bearing of risk defeats the objective of transferring the risk.4
For various reasons, a plan for risk management across time, or during the progression of events, might include the shifting of certain risks among/between parties at different points in time or with respect to particular events and outcomes. For instance, a company may choose to avoid certain risk factors during the construction of a new facility by resorting to a turnkey contract. Naturally, confidence that the party accepting the risk can comply and deliver is of paramount importance to avoid risk reversion.
Evaluate Risk Resolution with Events and/or Time
The outcome of one or more events associated with the progress of a project can have a profound effect on the level of the resolution of risk and the remaining risk for the rest of the project path. The successful synthesizing of a substance at the laboratory level and repeated replication of the synthesis can greatly alter the remaining risk in the project. Subsequent success in attaining the expected output and quality from a pilot plant would resolve more risk and cause a drop in the residual risk of the project.
Figure 1 depicts the general notion of risk resolution with events/time, without discussion of alternative scenarios and details. However, we share an example of a core issue: the commitment of capital at risk versus the resolution of risk. This example illustrates the shifting of a major risk-reduction event to an earlier point in time to resolve a major portion of uncertainty before committing the next chunk of capital. The initial risk resolution curve is shown in the figure.
As you might expect, shifting the resolution curve to the left, as indicated by the gray arrows, often entails additional costs. The analysis and decision to pursue this path should capture the relationship between those incremental costs, the chance of an unfavorable outcome, the investment schedule, and the cost of failure.
Other approaches to coping with the pattern of investment versus time versus risk resolution exist that are important if it is impossible, or prohibitively expensive, to shift the resolution curve. For example, one party desiring to participate in the venture might find it possible to take or create an option that allows it to participate if later on risk is resolved in a favorable manner. For example, a pharmaceutical company might take an option on another small company in the situation represented by the initial resolution curve, the relative bargaining positions obviously influencing the nature and terms of the option.
Divide Return and Risk Disproportionately
In many models of valuation, changes in cash returns have a linear effect on value. Changes in the required rate of return have a nonlinear effect on value. Table 1 illustrates these relationships with a present value problem. A to B to C involve changes in cash flow, with the same dollar effect on value—up or down $24.72 as the cash flows increase or decrease from the base value–highlighted with solid line boxes.
The discount rate reflects the risk of cash flows. D, E, and F illustrate the asymmetric effects of changes in the discount rate, with different dollar effects on value. An equal increase or decrease of 1% in the rate yields an unequal change in value ($22.56 vs. $20.50).
Know the Way Out
The best analysis will not overcome the reality that we don’t know what the future holds. Even if we choose a course of action that passes all the common sense tests, we still should always ask: How do I get out of here if…?
We hope we will not have to escape a particular circumstance. Giving some thought to that possibility will prepare us for such an undesirable outcome—even though we may take an entirely different path from those identified in this process. People are remarkably resilient and creative. Thinking through things ahead of time somehow prepares the mind to work at its best, no matter what happens.
The Common Sense Test
A final step in the analysis of a decision to be taken is the power of an important question: Does the contemplated course of action make sense? Step back from the details of analysis, and from any obsession with the project, and weigh it up from the perspective of an independent observer.