Risk Management: Behavior Is Key

“Loss aversion is the systematic mistake of segregating gains and losses — evaluating decisions in isolation rather than in the aggregate — and over-weighting losses relative to gains,” according to Maurice Schweitzer, professor of Operations & Information Management at The Wharton School of Business.

Prof. Schweitzer makes this assertion based on growing studies on the impact of behavior on decision making. This is important because behavioral analysis increasingly shows that we often do not make economically rational decisions – even when we are ‘experts’. For example, a study of top golfers has shown that they tend towards safe shots, rather than winning shots. And hence the observation that even they – as leading experts – focus on the immediate risk of doing well on a specific hole, rather than their overall tournament score.

This is highly relevant to all those in the world of contracting, because the comparison relates to our focus on individual transactions, rather than on the portfolio of contracts and relationships. By having this focus, not only do we sub-optimize business results, but we also create unintended risks.

Sub-optimization occurs because ‘playing it safe’ most or all of the time results in a predictable outcome, but one where we can rarely emerge as big-time winners. We fail to gain competitive edge because we consistently achieve par, but rarely score a birdie. Unintended risk arises because we are concentrating on the acceptability of individual deals and not the cumulative effect of many deals. The collapse of the bankign industry is a classic example; each individual sub-prime mortgage made perfect sense. Many thousands did not.

The Wharton study goes on to observe  that behavior “reflects a bias towards avoiding loss” , In business people view performance in the context of a specific account, or a particular contract …. “People make mistakes when they view related decisions independently.” The study also refers to Prospect Theory, a concept in economics which was developed by psychologists Daniel Kahneman and Amos Tversky in 1979. Prospect Theory predicts that people become more risk averse when they are recording gains than when at risk of suffering a loss. Again, for those in the world of contracts and the law, this reflects our tendency to seek holes in new opportunities – which of course is frustrating for the optimists in sales and often also for executive management.

What lessons should we learn? Perhaps the key point is that we must find ways to undertake analysis and make risk judgments in a more composite fashion. We need tools that allow individual decisions to be made in the context of the overall contracts portfolio and that offer visibility to past experience across the organization. Most contracts and legal groups undertake deal analysis and review on a case by case basis that relies almost exclsuively on individual judgment. We lack data to observe volumes or patterns. Our insight to portfolio risk and opportunity is typically limited to personal or team experience. As a result, we are most likely overly conservative on individual opportunities – but may be guilty of allowing unacceptable risks to arise in the overall business portfolio. In addition, the limits of our personal experience may leave us unaware of the perfectly good opportunities that we are missing as a result of overly cautious risk assessment.