Systematic Inaction in the Face of Uncertainty

Truly new and different consumer products are unavoidably characterized by uncertainty.  Consequently, making a major, irreversible commitment to the development, production, and marketing of such a product can be very risky.  On the other hand, new products represent desirable growth opportunities for companies in ever-changing markets.

So, how do companies manage risk and reward?  Unfortunately, it appears that most established companies, most of the time, avoid the risk, and fore-go the opportunity to create new value, through inaction.  In the face of uncertainty, they freeze.

Uncertainty is not the same thing as risk.  Risk is a function of the size of the bet made in the face of a given amount of uncertainty.  The odds of "winning" a game of Russian roulette are as high as 5 in 6, while the odds of winning the lottery are often less than 1 in a million.  The former is more risky.

A tried and true way to manage uncertainty is through phased investment  That's the way venture capitalists manage risk; they make a series of  investments as uncertainty is resolved.  High uncertainty-low investment rounds (sometimes) lead to lower uncertainty-higher investment rounds.  In other words, VCs invest in a series of call options:  the right, but not the obligation to make subsequent investments in growth opportunities over time.

There are at least two keys to using phased investments to manage risk:

• The size of each bet should be relatively small when compared to the potential size of the prize.
• To be an option, the holder/investor must be willing to abandon the right to make subsequent investments in the growth opportunity.  You have to be willing to walk away.

Most big companies, however, can't seem to even contemplate the prospects of abandoning a once-promising growth option (particularly one that looked very promising a scant few months previously).  As a result, they can't effectively implement phased investment.  That typically leaves them with a binary approach to dramatically new products:

• Do nothing.
• Make a big, blind commitment in the face of high uncertainty and hope for the best.

In that context, it's not surprising that conscientious decision-makers opt for the status quo.

I suspect that there are at least three reasons that established companies find it hard to manage risk in high uncertainty situations through effectively phased investment:

• Companies recruit smart, analytical, and conscientious employees, and the best become decision-makers.  They don't like to fail, and they don't like to quit.  Wait a minute...aren't those strengths?  Of course they are, but those same employees can be the least prepared to deal with failure of any scale or scope.  And, many small failures are the price of entry to a strategy of phased investment.
• Most big companies are hierarchical.  Hierarchy can help a big organization move quickly when need arises.  But hierarchy can also mean that the rewards of success and costs of failure are distributed asymmetrically. 
• Established companies, particularly public ones, tend to use net present value (NPV), variations of the capital asset pricing model (CAPM), and other related tools to estimate "shareholder value."  Implicit in these tools, however, is that investments are commitments.  Increased uncertainty means a higher discount rate, which decreases the present value of future cash flows.  But that understates option value, which increases in the face of uncertainty.  Consequently, these valuable tools can lead to systematic under-investment in early stage growth options. 

Discouragingly, it's a rare organization that can effectively apply a staged investment approach to new product development. I suspect that it takes courageous senior management who will commit to investment in numerous growth options over time, are willing to walk way from sunk costs without regret when uncertainty is resolved unfavorably, and who will, in effective, take the heat for unavoidable losses in order to enhance the organization's chances to identify winning growth options over time.