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Evaluating risk: Companies that want to innovate have options

Risk is a necessary element of successful innovation, but it need not be a gut-instinct decision. Here are some tools to help you assess and grow comfortable with risk.

It's easy enough to say innovation requires risk and, further, to insist that a culture of innovation requires a brave leadership. But even if you believe those assertions are true, you'll still probably feel a lot more comfortable taking risks if there were some way to quantify the need to do so. Well, there is. There are, in fact, a multitude.

"Innovation isn't some nebulous term that we don't know how to tackle in our industry," says Craig Partridge, worldwide senior director of the advisory and transformation practice at HPE Pointnext Services. "Nor is it a kind of chaos. There are actually some very good methods that need to be applied to companies that want to innovate. There are clear methodologies for how to organize for success."

He suggests options such as using design thinking as a way of forming and brainstorming ideas you think are going to make the difference; moving design thinking into practices like agile, to iterate; and moving to a minimum viable product approach.

If that is still not numerate enough for your taste, does anyone have a straight-up equation you can employ in assessing risk?

It's all in the math

"I have an equation," says Lanny Vincent, principal of Vincent and Associates and adjunct lecturer at Santa Clara University. "It goes like this: T=(CxAC)/R. Trust equals competence times authentic communication divided by risk."

Defining his terms, Vincent says that in an entrepreneurial context, in which you're innovating, competence means experience.

"Competence always tends to be low, since by its definition, you've never done this before, though you may have done similar things," he says. "Authentic communication I define as a dialogue in which you're not responding to someone as a caricature or symbol. You're creating a two-way street. Risk, then, is either perceived or real."

As risk goes up, Vincent notes, trust goes down.

"Interestingly, trust only goes up slowly and it only goes down rapidly. But risk, on the other hand, rises quickly and only declines slowly. Risk and trust form a reverse curve."

Another useful structure for risk assessment Vincent finds useful is the Cynefin framework, a typology for different kinds of decision-making contexts. Those contexts can be simple, complicated, complex, and chaotic, and they are not fixed. They can drift and move into each other.

"If you're in a complex, a chaotic, or even a complicated context, uncertainty goes up along with the perceived risk, because it's difficult to determine what all the factors are that are playing out," says Vincent. "It's similar in many respects to an entrepreneurial environment because the uncertainty is relatively high."

 

Risk, in other words, is context-dependent. It's never an isolated variable. You really cannot legitimately assess risk without understanding the context you're operating in at a given time. Risk, according to the Cynefin framework, will look different in an innovation context than it will in an operational one.

"Often, there is confusion between ambiguity and uncertainty," says Vincent. "Uncertainty can never really be eliminated, but it can be lowered by new information. However, ambiguity is not reduced by new information. It's reduced by clarity. Risk is in direct proportion to uncertainty. One of the key acts of leadership is to have the clarity to reduce your followers' ambiguity."

Another connection Vincent makes is between risk and what's called sense-making literature, a type of organizational psychology derived from the work of Karl Weick and others. Weick's seminal work, "Sensemaking in Organizations," recognized that ambiguity had been left out of the dominant theory of strategic rationality.

"Weick says when you're invested in your identity, your professional identity, you're much more likely to avoid risk," explains Vincent. "His theory of sense-making is very interesting because it explains how our vision can be skewed and distorted by our sense of who we are, our professional identity in particular, and attempts to support it."

According to Weick, as soon as someone becomes popular in their employment context, they have a "professional proof persona" they feel they have to defend. Weick calls this one of the key aspects of sense-making. In one sense, you may have built your reputation on paying attention to a certain thing and you become a recognized expert in that thing.

"It's in the defense of your reputation that you begin to grow less free," says Vincent. "It's risky for you to acknowledge complexity that exceeds the grasp of your expertise."

When are you most likely to take risks?

A key to discerning when you should take a risk is in understanding your likeliness to embrace or avoid a change in a given situation. To figure that out, we spoke with a pioneer of behavioral finance, Hersh Shefrin, the Mario Belotti chair in the Department of Finance at Santa Clara University's Leavey School of Business.

"The issue is how where you want to be and where you are line up," explains Shefrin. "Do I want to be No. 1 or No. 2 in my key markets? What do I want my market valuation to be? I compare it to where I am now, and I think about the gap."

In his paper "Focal Points and Firm Risks," Shefrin and his colleague Ye Cai tested what's known as the March-Shapira model against industry standing and risk.

What March and Shapira say is that where you want to be, compared with where you currently are, is going to be a key driver of risk appetite.

"If we were in a situation where we have realistic goals and we feel we've met or exceeded those goals, that tends to actually make us cautious, because we're really very concerned about taking a risk whose outcome might lead us to fall short when we're already at or ahead of where we wanted to be," says Shefrin.

If you're below where you want to be, you tend to have a different attitude toward risk.

"Then we become much more comfortable taking a fair amount of risk because the upside really looms large for us," says Shefrin. "We really want to achieve or beat our aspirations."

Finally, March and Shapira maintain that if you're bottoming out—close to going out of business, for instance—it's likely that your focal point will switch from where you want to be to the imminent threat of liquidation and that will induce you to be cautious again.

"We tested this with board members and company executives," says Shefrin. "Lo and behold, we've got this very striking empirical finding that the part of the March-Shapira story that holds water is the part that says if you're above industry performance, you're conservative. If you're below industry performance, you're much more willing to take risks and the further away you go—meaning the worse your performance is relative to industry average—the more risk you take."

The surprising part of Shefrin and Cai's findings relate to the last part of the March-Shapira theory, the one that says if you're so bad that you actually have a realistic prospect of going bankrupt and liquidating, then you become very cautious.

"We found no evidence for that," says Shefrin. "We just find that companies in those situations are much more prone to take on high risk than be cautious."

Structures for safer risk

"The shift towards agile practices has enabled us to go and test technology features almost in real time now," Partridge reminds us, at least in the software and services industries. "We're getting features and feature updates coming out by the dozen, in a single day sometimes."

In agile software development, a company can take a restricted risk on a new approach. It can release a microfeature to, say, 5 percent of its user base and figure out if that's something those users like before deciding to roll it out to all of its base. While this doesn't require an agile approach, it works best as a standard part of your process.

Additionally, says Partridge, we talk about organizations that are moving into the digital area needing to become cloud-enabled. The benefit of making that move is that it reduces the risk behind innovation.

"In a consumption-driven market in which you can actually test at relatively low capital investment, it allows the innovation cycles to not only speed up but to get grander in their ambitions," explains Partridge. "With any innovation that is proven to fail at a minimum viable level, you can just turn off the service delivery platforms and stop paying for it."

Innovation is necessary for growth and to avoid cannibalizing your customer base. Risk is a necessary element of successful innovation. But taking a risk need not, and perhaps should not, be solely a gut-instinct decision. The equations and processes described here should help you assess risk and grow comfortable with it but control those aspects of it that can be controlled.

There is, however, no such thing as safe innovation—because that would require no risk, and without risk, there is no innovation. Fear of risk may be a key obstacle to growth.

"Managements have a tendency to respond to risk with a range of human responses," says Joel Peterson, the Robert L. Joss adjunct professor of management at Stanford Graduate School of Business and chairman of the board of overseers at the Hoover Institution. "These include cognitive lock-in (a tendency to stick with first reactions); task saturation (losing sight of the big picture); groupthink (the tendency to go along with consensus); and availability bias (making decisions based on the most readily available information)."

The negative effects of such actions and inactions on a business are monumental. So confronting them is integral.

"There are pathways to get you there," says Partridge. But they're always a risk.

Risk as an equation: Lessons for leaders

  • Determine how you are going to make decisions, and understand the context for each decision.
  • Set goals and targets that are clearly definable.
  • Consider how a consumption-driven market will impact your choices.

Related risk-taking reading:

Innovation requires risk, and risk requires leadership

Encourage risk-taking with the right innovation structures

Diversity in risk-taking: Why every voice matters

This article/content was written by the individual writer identified and does not necessarily reflect the view of Hewlett Packard Enterprise Company.