A refrain I hear often among STM and scholarly publishers when asked why they are so often reluctant or slow to bring new products to market is, “We are risk averse.” I’ve been hearing this for my entire career – from colleagues at the organizations I’ve worked, as a consultant working with a variety of different organizations, and now as a technologist. I have heard this same refrain from small as well as large organizations, from CEOs to product managers, and from both not-for-profit organizations and commercial publishers.
At first I thought this was just another way of saying that they are change averse, and indeed perhaps there is some truth in that. Megan McArdle’s excellent piece in the Atlantic on GM (“Why Companies Fail”) describes how organizations can become dysfunctional over the years due to corporate cultures that are so resistant to change that they might not be able to make course corrections even with oblivion looming directly ahead.
While I chalk up some of this resistance to new development to organizational change aversion, I don’t think that entirely explains it. Many individuals are genuinely talking about an aversion to “risk.” And by this they presumably mean that they do not like to take action or make investments unless the probability of success is extremely high. What is often not considered is that if the risk is very low, the return is likely to be equally low (this is what results in what Joe Esposito calls “extensionism” – incremental product enhancements with proportionately incremental results). What is considered even less often is that inaction (or insufficient action) can sometimes carry significantly greater risk than action.
Ruminating on such statements about risk over the years has led me to the following observations:
- Risk is poorly understood by nearly everyone (and especially those paid to study it)
- Indicators of risk are only as good as the assumptions they are based on
- Risk is contextual to the market one is operating in
- There is no business action that is risk-free, including inaction
- Risk is subjective, with different facets of risk being privileged over others, and with opportunity cost often getting short shrift
Risk is poorly understood — At the height of the economic boom that culminated in 2007, financial firms employed legions of the best and brightest – mathematicians and computer scientists drawn from the best universities in the world and armed with some of most powerful computers ever built – to better assess and mitigate risk.
These risk experts devised a number of strategies to mitigate risk. One was the mortgage-backed security. The idea of the mortgage-backed security is that it minimized the risk of both default and prepayment to a lending institution by securitizing, packaging, and selling buckets of mortgages. Instead of the lender bearing all the risk for the loans they were making, they could allow other financial institutions to purchase some or all of the loan note, thus sharing in the risk as well as the interest earned on the mortgage. The idea was to spread the risk around the market. The problem with this strategy is that it created systemic risk of such a magnitude that it nearly destroyed the entire global financial system. When no one owns risk, everyone owns it.
Oddly, very few of the risk experts saw this coming. Part of the problem was that the calculation of risk the experts relied on was based on certain assumptions. The assumptions they used did not account for systemic risk, nor did they account adequately for what Nassim Taleb has termed “Black Swan events.” The complex formulas used to assess risk gave a false sense of security: someone very smart has done the math on this, so we are covered. Of course, if the assumptions the math is based on are incomplete or erroneous, the best mathematicians in the world (and the financial firms employ some of the best mathematicians in the world) are not going to be helpful. Garbage in, garbage out.
This false sense of safety was exacerbated by the ratings agencies that were similarly supposed to be assessing the risk of various securities. These agencies were again basing their calculation on known variables. In Michael Lewis’s recent book “Boomerang,” he describes the German banks, IKB and Commerzbank (among others), which kept buying mortgage-backed securities even after the rest of the market realized how toxic they were. The reason? These securities had AAA ratings and were considered risk-free. The (German) bankers trusted the (American) ratings agencies to the point that they considered AAA rated securities as being essentially risk-free and kept buying them even when evidence to the contrary emerged.
The funny thing about risk is that it does not care what you know or don’t know. Donald Rumsfeld, in a feat of rhetorical gymnastics that should be studied by every high school speech class, famously delineated between “known unknowns” and “unknown unknowns.” There are the things that you know you don’t know, and then the things you don’t know that you don’t know. The mathematicians and the ratings agencies were only dealing with the first kind of unknown, whereas it’s the second kind that tends to sneak up and bite you on your hind parts.
Risk is contextual — A risky versus less-risky position is entirely dependent on the conditions at that point in time. An organization I am acquainted with produces a data product. Fifteen years ago, this data product was far and away the market leader with sales exceeding that of all competitors combined. Over the last decade, this organization’s competitors have made substantial improvements in their product offerings, moving aggressively to online distribution and bringing more and more sophisticated products and feature sets to market. During the same period, this organization has made no substantive investments in their product, still offering largely the same thing they did 15 years ago with only incremental product extensions. When asked why they have not invested more in their product line, they point out that they are risk-averse and, anyway, they have seen steady increases in their sales year-over-year. And while it’s true that they have seen small but steady sales increase every year, it is also true that the market has grown dramatically over this time and they have hemorrhaged market share. While once far-and-away the market leader, their product now accounts for a minority of overall market sales. The opportunity cost of inaction over the last decade and a half can be measured in hundreds of millions of dollars in annual revenue foregone.
That opportunity cost, of course, pales in comparison to the leads squandered, and billions in revenue forgone, by Microsoft, Palm, and RIM in the mobile handset markets over the last five years due to effectively doing not much of anything while Apple and Google have swept in and commandeered the market. Apple now makes more revenue from its mobile products alone — a category that didn’t even exist at Apple a few years ago — than is generated by the entire Microsoft corporation. Microsoft once had a significant lead in mobile, and their inaction has not simply cost them the revenue they’ve lost but the revenue represented by the share they’ve lost in a rapidly expanding market.
There are times when doing nothing is indeed the less risky course. In other times, when the market is growing and your competitors are moving quickly, doing nothing is the most risky thing you can do. It’s important to understand that there is no action, including inaction, that one can make in business that carries no risk, and there are times when inaction carries significantly more risk than action.
Risk is subjective — Risk is subjective in the sense that different people are assessing different things even dealing with the same set of data. Let me give you an example from a recent vacation. I went skiing over the holidays with a friend. We waited until the last possible moment – days before the trip – to book flights and hotels. The reason for this was that snowfall has been very spotty this season in the US, and around the holidays it was unclear which part of the country would even have enough snow to ski. As it turns out, Taos, New Mexico, received a good deal of snow in late December and that’s where we ended up going. We lucked out, and there was a last minute cancellation at the lodge we wanted to stay. Over dinner at the lodge one night, we spoke with a woman who was there with her family. She was shocked to hear we had just booked our air tickets and accommodations days earlier. “That is very risky,” she said. “We booked over six months ago to ensure we could find good accommodations and get a good deal on airfare.” On her ski vacation she was mitigating the risk of higher airfares and less optimal lodging but was not mitigating for the risk that there would be no snow. We, on the other hand, were willing to forgo optimal lodging and fly sub-optimal times or routes and/or pay more in order to mitigate the risk of there being no snow (as to our thinking, the best lodging on the mountain is not of much use on a ski vacation if there is no snow to ski on). While neither of us was right or wrong, it is important to be clear about precisely which risk is being mitigated.
The kind of risk that usually gets short shrift is opportunity cost, as it is the most difficult to assess, even after the fact. An overly cautious business manager can attribute a loss of market share, especially in a rapidly changing environment, to other factors — especially if the market is growing and revenues are not declining (or if the market is contracting overall, as is the library market in STM). I have found this phenomenon especially prominent among professional associations where executive directors and boards of directors are often appointed from the ranks of the association’s specialty and can have limited knowledge of the publishing environment and often limited business experience. Because of this, managers often have a high bar in making the case for funds for investment in new products but are conversely able to brush many opportunity costs handily under the carpet.
Managing risk — Given these observations on risk, what is a business manger to do? First and foremost, it is necessary to understand the assumptions your organization is working from. Assumptions that are inaccurate or misleading will likely result in poor decision-making. All assumptions will necessarily prove incomplete – no one has perfect knowledge of the present never mind the future. But it is critical to know what has been factored into the assumptions and what has not. Here we are mainly talking about the “known unknowns” because of course the “unknown unknowns” – the Black Swans — are just that (unknown), but they are out there, circling just beyond sight, ready to alight at any time.
But the possibility of Black Swans ought not necessarily inhibit action.The question isn’t whether you take on risk, but rather what risks you are willing to take and which risks you are less comfortable with. Inaction or being late to market can indeed be a way of limiting risk – it can also be the most risky position of all depending on the particulars of your market and your product.
The old adage about not keeping all your eggs in one basket is generally a good one – diversity is a good hedge against the risk of any one product failing. This would lead one to a strategy focused on a broad array of product development. Certainly this has paid off for companies like GE, 3M, and Microsoft. Microsoft, for example, due to revenue from its other product lines, has been able to recover from fumbling its mobile strategy, whereas RIM and Palm, which are/were focused exclusively on mobile handsets, have not. On the other hand, there is a different kind of risk in diversification. The risk is that you lose focus and blockbuster products (or products with blockbuster potential) don’t get the attention they need. Larry Page, taking the advice given him by Steve Jobs shortly before he died, decided upon taking back the mantle of CEO at Google that the company had lost focus and needed to limit the number of products it devoted resources to. The balancing point between diversification and focus will be different for each organization, but it is a balancing point that is ideally determined purposefully and not by default.
Finding this balancing point is not easy. Nor is navigating the constantly changing market conditions that provides the context for assessments of risk. Understanding the assumptions that underly our decision-making, and their inherent limitations and subjective perspectives, is likewise challenging. But without taking these steps, you have no way of knowing whether inaction incurs less risk than action. Indeed inaction may prove far more risky in certain markets at certain points in time than the boldest of adventures.