The risk–reward analysis charts potential rewards of strategic options against the associated risk. The result is an assessment of the attractiveness of strategic options, serving as a basis for decisions to allocate resources. The risk–reward analysis works in the same way as a risk–return analysis for valuing financial products such as bonds and options (Figure 33.1).
Figure 33.1 Risk–reward analysis
The risk–reward analysis can be performed at any level of detail. The CEO could do it on the back of an envelope, or he or she might ask a team of analysts to perform a fully fledged analysis, including extensive market research, return on investment (ROI) calculations, scenario development and sensitivity analysis. The fundamental steps remain the same.
By using this tool, one can compare completely different types of projects and combinations of projects. Combining projects may add up to a balanced resource allocation that fits the acceptable risk profile of the company. However, the model is not able to show variance in risk and reward if certain strategic options are combined in different models. The interconnectedness of strategic options is not taken into account.
A risk–reward analysis starts with drawing up a list of feasible strategic options and their potential rewards. For example, options might include international market development; new product introduction; professionalising the purchase department; and outsourcing production. Together, investments, additional savings and/or reduced costs represent a potential reward that can be quantified. Often information on qualitative factors such as a better image, completeness of product range and strategic expansion of capacities like technology are also included to assess the potential return of a strategic option.
Subsequently, a thorough analysis must be carried out for each strategic option to assess the associated risk. Factors to consider in this respect include the level of investment, industry threats, cut-off from other options, effects on supply chain relations and exit barriers, but also factors such as exclusion of other options and vulnerability from overstretching financial reserves.
The options can then be plotted in a risk–reward analysis chart, with risk on one axis and reward on the other. Once all the options are plotted in the risk–reward analysis chart, a brainstorming session is useful to find ways to reduce the risk associated with options that have high reward potential. In a similar vein, methods must be found to increase the reward of relatively safe options. These discussions result in a prioritisation of the different options.
The risk–reward analysis can be extended with a third dimension to become a risk–reward resource analysis. The amount of resources required is then represented in the diagram (by bubble size). Options that require large amounts of resources are plotted with larger bubbles than options that require fewer resources. This enables one to trade off risks, rewards and resources or to find the best options.
Ultimately, the objective is to balance risks, rewards and resources according the company’s desired risk profile. Organisations with an aversion to risk will focus on decisions for the long-term continuation of the organisation, and will therefore accept fewer possible rewards. A more entrepreneurial, risk-seeking company might accept higher risks as it chases higher rewards. Nevertheless, there should be a positive balance between the two.
One of the prevailing pitfalls in management is that decisions are made with limited information and a lack of multiple perspectives. Inaccurate, optimistic or unrealistic predictions about the potential rewards of strategic options push risk analysis into the background. The estimated risk, on the other hand, tends to be underestimated. The result is an overvaluation of the options the organisation has.
The drawback of the model is that the evaluation of the dimensions, risk, reward and possible resources, is the result of a complex interaction of factors. The weight of each factor and the interrelation among factors are generally affected by emotions.
To maximise the effect of the use of the risk–reward analysis, it is advisable to compare the possibilities extensively to minimise the number of options. Furthermore, it is recommended that the details of all potential risks and rewards are analysed sufficiently. The greatest pitfall is to oversimplify the situation and not pay enough attention to the interrelatedness and complexity of factors.
Sperandeo, V. (1994) Trader VIC II: Principles of Professional Speculation. Hoboken, NJ: John Wiley & Sons.