Useful tips on how to get risk fit

Risk is influenced by people’s perceptions and decission-making

GREGG BARRETT

I N MY recent journey through the IACCM Managed Learning programme (www.iaccm.com), I was exposed to a very interesting exercise that participants are required to participate in. The exercise covers risk, people’s perceptions of it and its impact on decision making. With risk so high on the corporate agenda such exercises are interesting and extremely valuable.

To appreciate just how people adjust their views on risk based on changes in information and circumstance, let me take you through the exercise and how people responded.

The situation:

You have a friend who is a wealthy entrepreneur. She has made a lot of money through successful new ventures and business initiatives. You know she has also made many of her family and friends wealthy who invested in her schemes.

She writes to tell you that she has identified a new opportunity and is seeking investors for it. She is making this offer to only 100 people and needs each of them to invest a minimum of R200 000 raising at least R20 million in total. She will be investing R5 million of her own money and will only proceed – and draw on your investment – if she reaches the total of R25 million that is required.

She estimates that your return from this investment will be at least R1 million and that this will be achieved in two years.

The problem is, you do not have easy access to R200 000. Your only significant asset is your house, which is worth about R350 000 and you have an existing home loan of nearly R100 000. So you would have to raise money by borrowing against your house as security

Decision point One:

You consult two friends – one is an accountant, the other a lawyer. You ask if they could check out your friend and the success rate of her past ventures. They tell you several days later that she appears to be very honest.

Would you make this investment if they told you that:

a) Less than 50% of past ventures have been successfulb) Between 50% and 65% have been successfulc) Between 65% and 80% have been successfuld) More than 80% have been successful

e) I will not invest under any circumstances or unless there is an absolute commitment to getting my money back

What people answered:

a) 1%b) 2%c) 12%d) 36%e) 48%

Decision point 1 is designed to illustrate the significant variations in our personal attitudes to risk – our propensity to accept risk.

Decision point Two:

There are now two days to go before the offer closes. You learn that it is significantly oversubscribed and many people decided to invest more than the minimum amount. This does not affect your ability to invest nor does it change the rate of forecast return. You know some of those who have decided to offer a higher investment are respected and seasoned business people.

Based on this new information, confirm the level of past success you require to make this investment:

a) Less than 50% of past ventures have been successfulb) Between 50% and 65% have been successfulc) Between 65% and 80% have been successfuld) More than 80% have been successfule) I will not invest under any circumstances or unless there is an absolute commitment to getting my money back

What people answered:

a) 1%b) 5%c) 19%d) 36%e) 38%

In this scenario you learn the offering is over-subscribed. This has no real bearing on the level of risk. It is similar to the herd instinct that led to mass investment in internet stocks or similar “mass” activities. The fear is that you will be left out and reputational risk takes over from sound judgment.

Decision point Three

There is something else you should know. Your five- year-old son has just been diagnosed with a rare disease. It is not immediately life-threatening but he is likely to become permanently and severely disabled unless he is treated in three years. The treatment is

expensive and will not be fully covered by your health plan. If your son is treated, the chances of a full recovery are almost 100%, if he is not, the probability of disablement is more than 90%. To get the treatment, you must somehow raise at least R750 000 in the next three years.

Based on this new information, confirm the level of past success you require to make this investment:

a) Less than 50% of past ventures have been successfulb) Between 50% and 65% have been successfulc) Between 65% and 80% have been successfuld) More than 80% have been successfule) I will not invest under any circumstances or unless there is an absolute commitment to getting my money back

What people answered:

a) 8%b) 11%c) 17%d) 28%e) 36%

In this scenario, your son is entered into the equation. The logic here is that those in a low-risk situation should increase their risk position. You have no other way to raise the money you need.

This offers a higher probability than anything else to get hold of the R500 000 that you need to supplement your existing home equity. Next week I will cover the remaining two decision points in the exercise and what my responses were. Interestingly, a number of organisations have moved towards such exercises in staff screening for positions and to assess decision-making competence and risk tolerance. The results of such exercises have also been supplemented with real world outcomes.

The results and models that have originated from such exercises are beyond the scope of this article but provide for an interesting study.

TAKING A RISK . . . People often adjust their views and opinions on risk based on changes in information and circumstance