Balancing Compensated and Uncompensated Risks in Business: A Historical Perspective

What do you call an entrepreneur who takes a lot of risks and always succeeds? A lucky duck!

Risk is a constant companion in life and business, but not all risks are created equal. From a business perspective, every strategy taken by a company carries with it the potential for reward and failure. Some risks can be anticipated, calculated, and even controlled, while others are unpredictable and outside of our control - which is part and parcel of running a business (particularly a scale-up).

So if taking calculated risks is necessary for any business, how can we effectively take compensated risks?

The human brain is not very good at distinguishing between compensated and uncompensated risks. We tend to focus more on the potential consequences of a risk than the probability of it occurring. We are also more likely to perceive risks that are unfamiliar or that evoke a strong emotional response, such as fear. There is also the optimism bias - the tendency to believe that one is less likely to experience negative events - this encourages us to over-index on the likelihood of encountering positive events. While optimism bias can have some disadvantages, such as leading individuals to underestimate risks, it also has some advantages (particularly when we are starting a business).

To succeed in this complex and ever-changing environment, businesses must balance the need to pursue opportunities with the need to mitigate the impact of negative outcomes. This balance is achieved by weighing the trade-off between compensated and uncompensated risks.

What does this mean in practice? Compensated risks optimises for a potential reward that compensates for the risk the business is taking. This reward can come in the form of increased profits, market share, or brand recognition. For example, companies that invest in research and development (R&D) often take on compensated risks. This is the reason why one needs to be careful of curring R&D costs when times are tough. You may invest significant amounts of resources into new products or technologies that may not yield results for several years. However, if the product is successful, the rewards can be substantial. In this case, the company is compensating itself for the risk it is taking by investing in something that has the potential to pay off in the future. They are risks that are calculated and planned for, rather than risks that are taken blindly. In other words, compensated risks are risks that are worth taking because the potential reward outweighs the potential downside.

On the other hand, uncompensated risks are those that carry potential consequences but do not offer any offsetting rewards. For example, the 2008 financial crisis was an example of an uncompensated risk that had a profound impact on the global economy. Companies that were heavily invested in mortgage-backed securities (MBS) saw the value of their investments plummet overnight, leaving them with massive losses and no offsetting rewards. The one who did tail-hedging were rewarded in the end.

In order to effectively manage risk, businesses must have a clear understanding of both compensated and uncompensated risks and develop strategies that balance the two. Let’s take a look at some strategies that can help you effectively take compensated risks in business.

Start Small and Test Your Ideas: One way to take compensated risks is to start small and test your ideas before committing a large amount of resources. This approach is often referred to as the “lean startup” methodology, and it involves creating a minimum viable product (MVP) that fulfills the minimum viable experience (MVE) so that you can test your idea with customers.

Conduct Thorough Market Research: In their book Blue Ocean Strategy, authors Renée Mauborgne and W. Chan Kim (both professors at INSEAD Business School) explain that conducting market research can help you identify untapped market opportunities and create a unique value proposition that sets you apart from competitors. By taking a calculated risk on a new market opportunity, you can potentially capture a larger market share and grow your business. For scale-ups, market research is still important. As a business grows, it is important to continue to stay informed about industry trends and customer needs. By doing so, you can identify new opportunities for growth and continue to take calculated risks.

Develop a Risk Management Plan: Taking risks in business is necessary, but it is important to have a risk management plan in place to mitigate potential downsides. A risk management plan should identify potential risks and develop strategies for managing them. By identifying potential risks and developing strategies for managing them, entrepreneurs can take calculated risks with more confidence.

One famous example of a company that successfully managed compensated and uncompensated risks was Johnson & Johnson. In 1982, the company faced a major crisis when seven people died after taking Tylenol, a painkiller drug produced by the company. Johnson & Johnson responded to the crisis with a well-coordinated, transparent, and compassionate response that demonstrated its commitment to safety and quality. The company immediately pulled all Tylenol products from store shelves, launched an investigation into the cause of the contamination, and developed tamper-resistant packaging. By handling the crisis by putting the customers first, Johnson & Johnson was able to not only mitigate the impact of the crisis but also establish itself as a trusted and responsible corporate citizen.

Risk is an inevitable part of doing business. However, companies that are able to balance the trade-off between compensated and uncompensated risks are more likely to succeed in the long run. Whether through diversification, risk management technologies, or a commitment to responsible corporate citizenship, businesses can manage risk and achieve their goals. By understanding the historical examples of companies that have successfully navigated these challenges, we can gain valuable insights into the best practices and strategies for managing risk.

What about asymmetric risk?

Asymmetric risks are risks where the potential reward is higher than the potential risk. They are rare to find, but they can be great for any business if identified and executed properly. These types of risks are more likely to be found in emerging markets or industries where there is little competition and innovation. We will be discussing this in detail in a future blog post.

Further Reading

“Thinking, Fast and Slow” by Daniel Kahneman - This is one of the best books I have ever read. It explores the various biases and heuristics that affect our decision-making, including our tendency to overestimate risks and the impact of emotions on our choices (i.e. when your brain is in system 1 vs system 2).

“The Black Swan: The Impact of the Highly Improbable” by Nassim Nicholas Taleb - It explores the impact of rare and unpredictable events, and the limitations of our ability to predict and manage risk.