This article previously appeared in the Rochester Business Journal and is republished here with permission.
Most Saturday mornings, I get up before the rest of the family and prepare my breakfast in a quiet house.
Once I sit down to eat, I like to tune in to a documentary on Netflix regarding a subject matter I know nothing about. One fascinating documentary I saw recently was about people who do base jumping while wearing winged suits. The suits fill with air and form airfoil-shaped surfaces between their arms and bodies and in fabric between their legs.
The documentary interviewed the top participants in this sport and showcased breathtaking footage of these individuals. They jumped from high peaks and flew like Rocky the Squirrel just above the rocks and treetops—and sometimes between two cliff faces—at more than 125 miles per hour.
As you might imagine, this is a highly dangerous pastime; many of its participants have died over the years. While they live, however, they are rewarded with the raw thrill of flight in some of the most beautiful terrain on the planet.
I admire the skill and courage of these adventurers and envy them for the unforgettable experiences they must have flying down mountains. But, like most people, I find that the risks associated with the sport outweigh the reward I would get from giving it a try. So, you might say that my “risk appetite” is not as big as that of the flying base jumpers. That is certainly the case with respect to their sport, but it may not be the case in all other domains of my life. For example, even though I have chosen not to jump off of cliffs, one of my favorite pastimes is windsurfing. Given my experience with the sport and my swimming skills, I might be comfortable assuming more risk than my base-jumping counterparts when launching a one-manned craft into high winds on a white-capped lake. And so, even though there are certainly differences in the amount of risk individuals will accept in their lives, these differences only become meaningful in the context of the particular activities they may or may not choose to engage in. I think the same is true of businesses.
Risk is a constant factor in all business undertakings. When confronted with risks, business professionals must choose among one of four responses:
- Accept the risk without any further mitigation
- Avoid the risk by foregoing a business opportunity or halting certain activities
- Share the risk by hedging, purchasing insurance or other similar means
- Reduce the risk by investing in risk management
Management of enterprise risks is defined by the Committee of Sponsoring Organizations of the Treadway Commission’s Enterprise Risk Management Framework as: “[A] process, effected by an entity’s Board of Directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.” (Emphasis added.)
This guidance implies that business professionals must contemplate, if not calculate, their risk appetite. In a general sense, businesses vary substantially in the amount of risk they are comfortable taking. And there is some value in understanding where your firm might sit on the risk spectrum. However, I don’t think it is particularly meaningful to attempt to calculate your business’s risk appetite in the abstract. If you were to do so and, after careful deliberations, determine that your risk appetite was a 7 out of 10, it seems to me that this insight gives you very little guidance as to how to run your business in particular circumstances.
Instead, I think that calculating your risk appetite makes the most sense in the context of particular business opportunities you contemplate pursuing or of risks you may be confronting. Take, for example, two businesses that are deciding whether to construct a new manufacturing facility in Nigeria. Taking into consideration all of the risks and potential rewards, one business may elect to go forward with such a project while another may not. Without assigning any arbitrary number to either company’s “risk appetite,” the firm’s respective management teams have by their actions defined what their tolerance for risk is in the context of this particular project. But the decision each firm made in this particular case does not necessarily define the respective risk appetites of the two businesses in all cases. Just as with base jumpers and the non-base-jumping community, one of the two businesses in this example may take greater risk in some circumstances and less in others. The differences between your firm’s and others’ risk appetite in general are not as important as they are in the context of an actual business decision.
Instead of attempting to define your firm’s risk appetite by assigning a number to it, I think it is far more useful to take a look at each opportunity and its associated risk and judge the respective merits on a case-by-case basis. This provides the firm with the flexibility to take all the current circumstances into account before making a decision, rather than being unnecessarily hamstrung by a theoretical calculation of the firm’s risk appetite.
So, the next time you are trying to decide whether to pursue an important business opportunity, forget about attempting a risk appetite calculation in the abstract. Instead, consider how hungry you are and what’s on the menu before taking the first bite.
