Organizational Risk Tolerance
The degree of aversion to risk taking can be measured and expressed as a number called the risk tolerance. Risk tolerance also goes by terms such as exponential utility, risk preference, risk aversion, risk attitude, risk premium, and risk discounting. The risk tolerance is not the maximum amount that the decision maker can afford to lose, although decision makers and organizations with greater wealth generally have larger risk tolerances. Like hurdle rates, risk tolerance involves applying an adjustment that penalizes the value of a risky project.
The concept works as follows. If decision makers did not care about risk, they would want to "go with the odds", that is, they would want to make decisions so as to maximize expected value. The expected value is defined as the probability-weighted sum of the possible uncertain outcomes. Decision makers unconcerned about risk would want to maximize expected value because the expected value is the amount that they would obtain on average each time the uncertainty is faced. As an example, the expected value of a coin flip that pays $1 on "heads" and zero on "tails" is 50 cents.
For substantial risks, organizations as well as individuals tend to be risk averse, meaning that they value uncertainties at less than their expected values. The "certain equivalent" is defined as the amount of money for which a decision maker would be indifferent between receiving that amount for certain and receiving the uncertain outcomes of the gamble. For example, a risk-averse decision maker might assign a certain equivalent of $500,000 to a risky project with equal chances of yielding $0 and $2,000,000, even though the expected value for this alternative is $1,000,000.
One way to approximate the risk tolerance is to have senior decision makers, ideally, the CEO, answer the following hypothetical question. Suppose you have an opportunity to make a risky, but potentially profitable investment. The required investment is an amount R that, for the moment, is unspecified. The investment has a 50-50 chance of success. If it succeeds, it will generate the full amount invested, including the cost of capital, plus that amount again. In other words, the return will be R if the investment is successful. If the investment fails, half the investment will be lost, so the return is minus R/2. Figure 8 illustrates the opportunity. Note that the expected value of the investment is R/4.
Figure 8: What is the maximum amount (R) you would accept in this gamble?
If R were very low, most CEOs would want to make the investment. If R were very large, perhaps close to the market value of the enterprise, most CEOs would not take the investment. The risk tolerance is the amount R for which decision makers would just be indifferent between making and not making the investment. In other words, the risk tolerance is the value of R for which the certain equivalent of the investment is zero.
Various studies have been conducted to measure organizational risk tolerances. The results show that risk tolerances obtained from different executives within the same organization vary tremendously. Generally, those lower in the organization have lower risk tolerances. As a rough rule of thumb for publicly traded firms, typical risk tolerances at the CEO or Board level are equal to about 20% of the organization's market value.
Once risk tolerance has been established, the certain equivalent for any project can be obtained by subtracting a risk adjustment factor from the expected value of the uncertain future value to be derived from the project, see Figure 9. The risk adjustment factor depends on the risk tolerance and the amount of project risk. An important advantage of this approach is that a single risk tolerance can be established for the organization. Use of the common risk tolerance ensures that risks are treated consistently, thus avoiding the common bias in which greater levels of risk aversion tend to be applied by lower-level managers.
Figure 9: Adjusting project value for risk
Part 5 of this paper will describe the fifth and final reason organizations choose the wrong projects-inability to find the efficient frontier.