Your Company Is Too Risk-Averse

Here’s why and what to do about it.

by

and

Daniel Kahneman

by

and

Daniel Kahneman

From the Magazine (March–April 2020) · Long read

Summary.

In theory, companies create value for stakeholders by making risky investments. In practice, however, managers in large corporations routinely quash risky ideas in favor of marginal improvements, cost-cutting, and “safe” investments.

Why are managers in large, hierarchical organizations so risk-averse? Corporate incentives and control processes actively discourage managers from taking risks. Whereas CEOs consider each investment in the context of a greater portfolio, managers essentially bet their careers on every investment they make—even if outcomes are negligible to the corporation as a whole.

This article explains how loss aversion works, presents an analysis of just how much value manager attitudes toward investment risk leave on the table, and offers suggestions for changes in practices and systems.

Idea in Brief

The Problem

In theory, companies create value for stakeholders by making risky investments. In practice, however, managers in large corporations routinely quash risky ideas in favor of marginal improvements, cost-cutting, and “safe” investments.

The Cause

Most managers in large organizations are significantly more risk-averse than CEOs, who consider each investment in the context of a greater portfolio.

A New Approach

This article explains how loss aversion works, presents an analysis of just how much value managers’ attitudes toward investment risk leave on the table, and offers suggestions for changes in practices and systems.

In theory, companies are supposed to create value for stakeholders by making risky investments. And as long as no single failure will sink the enterprise, those investments may be quite large. It won’t matter if even a significant percentage of them fail so long as the success of other bets compensates, which usually happens. It’s an approach to investment that’s supported by economic theory going back to the 1950s work of Nobel laureate Harry Markowitz on portfolio optimization.

A version of this article appeared in the March–April 2020 issue of Harvard Business Review.

Dan Lovallo is a professor of business strategy at the University of Sydney Business School and a senior adviser to McKinsey & Company.
TK

Tim Koller is a partner at McKinsey in Stamford, Connecticut.
RU

Robert Uhlaner (robert_uhlaner@mckinsey.com) is a senior partner at McKinsey in San Francisco.
Daniel Kahneman is the Eugene Higgins Professor of Psychology, Emeritus, and Professor of Psychology and Public Affairs, Emeritus, at Princeton University. He was awarded the Nobel Prize in Economic Sciences in 2002 for his work (with Amos Tversky) on cognitive biases.

Your Company Is Too Risk-Averse

Idea in Brief

The Problem

The Cause

A New Approach

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