Risk: an unconventional approach

The comedian Robert “Bobcat” Goldthwaite had a routine about bad ideas, like the day someone decided to cook with an open flame on the Hindenburg.  Or, in all seriousness, someone decided that it was a good idea to board an airship attached to a giant ball of flammable gas.  What drives humans to make such stupid mistakes?  Economists think it has something to do with commonly held misconceptions about risk or, as Bobcat might put it, mass brain-damage.

I recently read Malcolm Gladwell’s excellent study of risk, “A Sure Thing”, which appeared in the January 10, 2010 issue of The New Yorker.  Gladwell says that many economists refute the commonly-held belief that people with a high tolerance for risk tend to be more successful businessmen and investors.  Specifically, Gladwell turns to some of “The Illusions of Entrepreneurship” debunked by Scott Shane.

According to Scott Shane, and contrary to conventional wisdom, successful entrepreneurs:

• secure adequate financing
• organize as a corporation rather than a sole proprietorship
• write a business plan
• take over an existing business rather than starting from scratch
• Focus on B2B rather than B2C
• Go after underserved markets to minimize competitive pressure
• Don’t underestimate the value of marketing and financial controls
• Don’t compete on price

Investors are also known to underestimate risk when:

• it is overplayed in the media
• it is a form of risk over which we have very little control
• it is tied to a very small return
• it is tied to something we find sinful or morally questionable

So next time you’re assessing risk, remember that you’re human and, therefore, probably wrong.