How do you take risks?
Ellsberg paradox
If you're an entrepreneur, you must often take risks simply because you create something new, be it a newsletter, a business model, or a product. And building up new things implies that you make an effort now but will be able to evaluate the results only later. And these results will not necessarily be positive.
A cognitive bias makes us believe that some risks are somehow "better" than others, which isn't true. We tend to take these risks more often, and this isn't the best strategy.
Learning about this bias and how to overcome it will help you make better strategic decisions.
A wall panels case
Many years ago, I was a CEO of a company that manufactured wall-finishing materials. Among them were wall decorative panels. And the business unit responsible for panels was the worst in the company from the point of view of financial results. Only a handful of our distributors bought these materials, and the unit remained loss-making for several years.
It was evident that I had to do something. I could close or sell the unit, but I thought it would have been a surrender. So I decided to relaunch the product, focusing on our strengths, such as low production cost.
When it came to designs for the new product line, I voted for the proven hits – the most popular patterns on the market. My logic was simple: if we offered our distributors and end consumers the same products that our competitors did but for a more attractive price, we would win the market.
And it was my mistake. Things got even worse.
Ellsberg paradox
Imagine that there are two urns, and each contains 100 balls. You know that urn A contains 50 red and 50 black, but urn B contains an unknown mix of red and black balls.
You can choose between four bets:
Bet 1A: get $1 if red is drawn from urn A, $0 otherwise
Bet 2A: get $1 if black is drawn from urn A, $0 otherwise
Bet 1B: get $1 if red is drawn from urn B, $0 otherwise
Bet 2B: get $1 if black is drawn from urn B, $0 otherwise
What would be your choice?
Daniel Ellsberg, an American political activist and former United States military analyst, described this experiment in his 1961 paper, "Risk, Ambiguity, and the Savage Axioms." He affirmed that participants chose Bet 1A and Bet 2A equally often, but they strictly prefer Bet 1A to Bet 1B and Bet 2A to 2B.
Technically the likelihood of getting $1 with urn B is the same as with urn A. But the fact that the ratio of red and black balls in urn A gave participants a false feeling of certainty.
People intrinsically dislike situations where they cannot attach probabilities to outcomes, in this case favoring the bet in which they know the probability and utility outcome (0.5 and $1, respectively).
Business risk
The popular panels' designs became my "urn A." I believed that the risk of launching a product line with familiar patterns was well-calculated. But I based my reasoning on the idea that the distributors' choice depended on two things only:
Product design
Price
I thought that if the design was ultimately the same and the price was lower, victory would be in my pocket.
But, as often happens, many other factors influence the distributors' decision-making process. So, the new product line failed, and we lost precious time.
Many risks are equal
Imagine that tomorrow you'll have a chess match. You may choose between two options – to play with a completely unknown rival or to play against someone about whom you know only one thing. For instance, you know that this person is a woman.
Chances are you'll choose the second option even though the data about the rival's sex provides little information. Women are not better or worse chess players than men. There is no special "female" style of chess. Knowing this won't enable you to build a winning strategy.
But knowing a little seems better than knowing nothing.
When we devise a business strategy and choose between strategic initiatives, we are often under the illusion that we base our decisions on two types of market data: "known unknowns" and "unknown unknowns."
We call "known unknowns" any information about a familiar market – for example, the market in which our company operates now. We admit that the future is full of uncertainty. But we believe our industrial experience will help us make a better choice.
And we call "unknown unknowns" any data about markets we've never worked in. So, any strategic initiative implying that our firm may enter those markets seems riskier to us.
But it is an illusion. If it weren't, any company which decided to stay in its market would be more successful than the one that dared to enter new business areas.
Conclusion
First of all, we need to admit that:
Business success depends on many factors
Most of them are beyond our observation
Points 1 and 2 make knowing little and knowing nothing equally dangerous for decision making
Even if you believe you know a lot about a market, a product, or a competitor, it is highly likely an illusion. So, we must do our homework of collecting as much information about any strategic option as possible. And we shouldn't rule out any strategic initiative on the sole ground that it seems riskier to us than others.