Your Perception of Likelihood Is, Most Likely, False
We can't weigh strategic risks correctly
An old joke says: what's the probability that you will walk out the door tomorrow and meet a dinosaur? It is precisely 50%. You will either bump into a dinosaur or not.
That's not true, of course. When I was a student in the Applied Mathematics Department at the university, probability theory was one of the most complex and boring subjects. But it's almost inapplicable for business purposes.
When we think strategically, we don't have to focus only on opportunities, and we also need to weigh the risks. Even if you don't belong to a secret society of risk managers, you may have heard about risk matrix. It helps divide all the risks you see into groups depending on their impact on our business and the probability of their occurrence.
And it is more difficult than it may seem.
Endowment effect
The grass is always greener on the other side. We tend to see the other options as more attractive than what we have. But we do it only in theory – as soon as we have to act, we become very conservative.
In 1991 behavioral scientists Daniel Kahneman, Jack Knetsch, and Richard Thaler conducted an experiment. They gave participants a mug and then offered to sell it or trade it for an equally valued alternative (pens). They found that the amount participants required as compensation for the mug once they owned it ("willingness to accept") was approximately twice as high as the amount they were willing to pay to acquire the mug ("willingness to pay").
Simply put, we tend to value what we already have much more than we could hypothetically get. A bird in the hand is worth two in the bush. The scientists called it "the endowment effect."
When a company's leaders think about strategy, they always have to options:
To make significant changes
To change nothing or little
And the endowment effect always makes them believe that the fewer changes they make, the less risk they take. Because what they have – business as usual – looks so stable and robust, whereas any new idea pushes them into the zone of uncertainty.
So, we assess the risk of continuing to do "business as usual" as lower than the risk of trying something new. And this is the wrong idea.
How can we evaluate a risk?
No matter what risk managers say, there is no way to estimate the probability of any business risk.
In November 2019, all the experts would have assessed the likelihood of the global pandemic as very low, but six months later, it happened.
Most people didn't believe that Russia would attack Ukraine, but it did.
Many business leaders didn't believe that e-commerce would ever seriously compete with traditional retail, but it does.
E-commerce pioneers didn't think they would ever open brick-and-mortar stores, but some did. For instance, Michael Preysman, founder of the digitally native apparel store Everlane, told the New York Times in 2012 that he'd rather shut the company down than open a physical location. Five years later, the company opened its first store in New York City.
You can find many stories online about Blockbuster's bosses laughing when Netflix's founders offered them to buy a company. Blockbuster's executives continued to believe that the risks of doing their business as usual were lower than to acquire Netflix, and they paid dearly for their mistake.
My point is that the risk of doing nothing or changing little is the same as that of turning your business model upside down. If you change nothing inside your business, someone else can change everything outside of it.
And in the long run doing nothing guarantees the death of your business.
So, don’t be afraid of changes. You will either meet a dinosaur or not. You’ll either win or lose.