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Fundamentals of Risk in Decisions – Part 3

In the third and final article of our three-part behavioral economics series, we discuss how to value risk and opportunity. Learn how to analyze the return on risk and make confident business decisions.

In part one and part two of this blog series, we outlined the concepts of risk in decision making, how that risk influences the decision maker and how that risk might appear larger than it is. We also outlined the concept for identifying, quantifying, analyzing and forecasting the probability of various risky and rewarding events.

This analysis gives the decision maker a clearer understanding of what they fear in the decision. By forcing evaluation of acceptable and non-acceptable outcomes, tolerance to negative outcomes, and “gut-feeling” of the probability and chance of event occurrences, the “fear” becomes “known” and less threatening as we now have a better understanding of what risks we need to manage or mitigate.

The three general rules of moving toward a favorable decision are:

  1. The ratio of the investment to the expected return influences the decision between financial risk and performance risk
  2. The level of risk tolerance should exceed the level of risk exposure
  3. The upside value potential should exceed the value being put at risk

The third rule of the decision process is that the upside potential value should exceed the value being put at risk. The upside potential is based on the value differential between the solutions. The value being put at risk, or downside, examines the potential losses that could occur within the context of the rated risks. Ideally, the former should be greater than the latter. For example, let’s assume you can make $1,000 performing some task, but if anything goes wrong, you’re out $100,000. Would you take that risk? Probably not, since there’s just not enough profit in that deal to assume a 100:1 risk, unless you have extreme confidence that you have effectively mitigated away all of the failure potential.

Here are three results that can be integrated into an overall decision framework:

  1. A risk-adjusted investment or TCO in an IT decision
  2. A return on risk
  3. An estimation of value impact

The risk adjustment is a function of the inherent risk and investment. For IT, we compare the inherent risk with the competing TCO values to determine a mitigation-versus-value opportunity offset. This offset is applied to the TCO to arrive at a risk-adjusted TCO, or a TCO that reflects the impact of the inherent risk. The risk-adjusted TCO will reflect an increase or decrease depending on the inherent risk factors.

The Return on Risk is determined as the ratio of the upside opportunity to the downside exposure as a function of the inherent risk and the investment ratio. If, as described in the first rule above, the financial risk is very small, then the return on risk may be largely driven by the inherent risk. Otherwise, a large financial risk tends to take precedence over the inherent risk. A positive return on risk suggests the potential for success in that decision is good, while a negative suggests a higher likelihood of failure.

Lastly, the overall impact on the value stream can be estimated by factoring the investment or TCO adjustments within the context of the investment ratio. This result will estimate the potential revenue or budgetary impact possible with the competing solutions.

Because the risk analysis process reveals risk and opportunity, these three results enable the decision maker to arrive at a more confident decision. The exercise of thinking about and measuring one’s emotions and beliefs about a solution, helps clarify thought and remove the fog of uncertainty.

In these articles, we have outlined a process for understanding financial risk, performance risk, emotion, and return outcomes. We have suggested ways these results can support a decision between competing alternatives. It is important to note that this methodology is a neutral, balanced approach; neither decision choice is favored or automatically assumed to be “best”.

VMware has been successful in leveraging this concept to help our customers not only support or justify decisions, but also gain insight into their own decision processes. This insight has led them to look at risk in a completely different way and draw the veil of uncertainty from IT decisions such as hybrid cloud migration.

We can mitigate risks we know about and can understand – it’s the risk uncertainty that we don’t understand that hinders us from making confident decisions. The VMware Cloud Economics group can provide that insight.

Resources to learn more:

Craig Stanley

Craig Stanley is a Group Product Line Marketing Manager in the Cloud Economics group. He specializes in economic cost analysis and the art of decision making. Craig has been in…

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