Risky Business

We all know that many businesses are frightened of investing right now. Plenty are sitting on mountains of idle cash. But are they guided by reason or fear?

A recent article and survey in the McKinsey Quarterly suggests the latter.

The piece acknowledges that there are plenty of rational reasons for holding back right now, “ranging from market volatility to fears of a double-dip recession to uncertainty about economic policy.” But it also believes that there’s another culprit at work: a “behavioral bias” among executives.

To bolster this point, the survey asked executives under what conditions they’d consider making an investment with a “possible loss of $100 million and a possible gain of $400 million” and learned that “most respondents were willing to accept a risk of loss only between 1 and 20 percent.” The McKinsey authors call this “excessive loss aversion.”

Peter Drucker understood that running any sort of business means taking chances. “It’s no accident that the word ‘risk’ itself in the original Arabic meant ‘earning one’s daily bread,’” he wrote in Management: Tasks, Responsibilities, Practices.

Photo credit: Pink Sherbert Photography

Drucker also sought to deflate any romantic notions of business leaders having an appetite for danger. “I know a good many successful innovators and entrepreneurs,” he noted in Innovation and Entrepreneurship. “Not one of them has a ‘propensity for risk-taking.’” Assessing and minimizing risk, wherever possible, was essential, precisely because risk is unavoidable.

[EXPAND More]So is the loss aversion we’re seeing truly excessive?

Having lived through the 1930s, Drucker was all too alert to the  “danger of defeatist underinvestment in a depression,” as he called it in Concept of the Corporation, when “nobody dares to invest.” (It was the pendulum reaction to “overspeculation.”)

But Drucker also felt that the pace of change was accelerating, and this required a certain degree of prudence.  “In turbulent times the need for capital formation is bound to go up, if only because turbulent times mean greater uncertainty and a higher risk premium on the committal of present and certain resources to the future,” he wrote. “We know that the times ahead are times of great change and innovation, socially and technologically—and this again means higher risks in the future.”

Why won’t companies invest more today? Are they being overly cautious, or is this a case of sensible restraint in turbulent times?[/EXPAND]