Thursday, May 24, 2007

Reducing the Risk

I used to work for a company which did a miserable job of managing the 401K savings accounts of its employees.

Every year the company went through the same ritual. First, they would tell the employees how poorly the money had been invested over the past year. It was always a return well below the average return which the rest of the market received.

Then they would announce that because of the horrible return, the company was changing to a different investment firm to manage the 401K account. The new 401 K managers were chosen based on having one of the highest returns over the past year (far higher than the returns the company received with the prior money managers).

Of course, after having such a banner year in the prior year, the new money managers would have a slump the following year (the year we switched our money to them). So after a year of suffering through their slump, they’d repeat the process all over again and hire yet another new management firm for the 401k. We were perpetually one year too late in benefiting from the good year of an investment company.

A major reason for doing strategy is to improve one’s risk. The idea is that if one takes time to think and plan strategically, it should decrease the risk of encountering problems (because you are better prepared and aware of potential pitfalls in advance) and increase the likelihood of success (by discovering high potential options). When dealing with risk, one needs to grasp the big picture.

The people who were deciding who should manage the 401 K accounts in the story above seemed to be missing the big picture. They would choose the financial managers based on a very short time horizon—typically looking at a track record of only a year or two. And then they would only keep the management firm for a year or two.

Investments tend to be cyclical, with high years and low years. Over the long haul, some investors are able to do better than average, but even the good investors can occasionally have a bad year or two. Similarly, poor investors can sometimes have a rare good year if they are lucky. If you only look at a short track record, and only keep an investment firm for a short period of time, you are more likely to:

1) Choose a poor investor who just finished a rare lucky year; and
2) Not get the full benefit of a good investor, because you may have only stayed with them during their rare unlucky year.

Had the company taken a broader view and either looked at a longer historical track record, or stayed with the current manager over a longer period, they could have mitigated the risk of low performance by smoothing out the occasional lows with the more frequent highs.

Strategists need to take a longer or broader view to improve their risk profile as well.

There are four key principles to understand when using strategic planning to improve your risk profile:

1) Risk = Reward
2) Risk is Minimized When Bundled at Same Time
3) Risk is Minimized When Stabilized Over Time
4) Risk is Minimized With Pruning

These are discussed in detail below.

1) Risk = Reward
The first thing to keep in mind is that the roll of strategy is not to eliminate risk. As the old saying goes, “Risk = Reward.” If you want to achieve outstanding rewards, you have to take some calculated risks. The goal of strategy is not to eliminate risk, but manage risk.

The only way to totally eliminate risk is to stay with the certainty of the status quo and make no investments. Unfortunately, this lack of risk leads to the absolute certainty that your company will die when the status quo eventually gets replaced by the next big thing.

To truly grow and have above average returns, one must make investments into unproven territory. If you wait until all the facts are known, others will invest before you and reap the rewards of the fast mover. By waiting until an industry is mature and well-defined, you will perpetually suffer from the mediocre returns inherent in mature businesses.

The role of strategic planning is to help your ventures into the unknown become less risky, by increasing what you know. First, strategic environmental analyses can help you understand how the marketplace is evolving. By knowing how the marketplace is evolving, you can better understand which new ventures are most in tune with that environment.

Second, by examining opportunities strategically, it is easier to understand which new ventures are inherently the least risky. Finally, by having a strategic plan which helps you build up core competencies, you can better determine which opportunities fit the strengths you have been developing. The more strengths you have that fit the needs of the new opportunity, the better you will be able to succeed in that venture, regardless of its inherent riskiness.

2) Risk is Minimized When Bundled at Same Time
If you put all of your eggs in one basket, your total risk is the same as the risk of the individual project. However, if you invest in a handful of new ventures, your total risk is less than the risks of the individual projects. When doing a bundle of ventures at the same time, the likelihood increases that you will find a winner within the bundle. Provided you get out of the losers soon enough and properly feed the winners, the likelihood of total success goes up significantly over the long haul.

Remember, the goal is not to make every individual investment a winner. The goal is to properly manage both the good and the bad in a manner that best optimizes the performance of the total corporation. Strategic planning can help you manage this ever-evolving portfolio.

3) Risk is Minimized When Stabilized Over Time
As we saw in the story about the 401K managers, if you keep changing management all the time, one increases the likelihood of have a string of bad performance. The same can be true in managing your strategy. Changing one’s strategic direction too often usually serves to hurt performance.

If you change your strategy for a given business investment too often, it can alienate your customers. They can become confused about what your brand stands for. If you are wishy-washy about what you stand for and keep changing your approach, the customers will be wishy-washy about their loyalty to you. Different strategies may require different competencies, which makes it difficult to develop any expertise. How can customers believe you are an expert, if you keep changing your expertise?

Sometimes, different strategies appeal to different customers. For example, if some customers prefer an everyday low price strategy. Others prefer a more promotional pricing environment. If you switch from one pricing strategy to the other, you could end up alienating your current customers and not pull in the other type of customers who prefer your new pricing position.

In retailing, I know from experience that every time one significantly changes the sales floor, there is an initial negative reaction from the confusion it causes. Constant change will turn of the retail customer.

It is a shame that the average tenure for a CMO is now under two years and that advertising agency changes have become such a frequent event. These changes make it hard to create the continuity which leads to strength and clarity with the customer.

Sometimes, the best action with a business is to do nothing and just let it build momentum from having a stable strategic platform.

4) Risk is Minimized With Pruning
Just as a grape vine can only produce the optimal number of grapes if it is regularly pruned, companies can only produce optimal results if the portfolio is regularly pruned. Yes, stability is important for an individual investment, but for the portfolio, it is often beneficial to add and subtract investments on a regular basis. Some firms are great at start-ups but not at running mature businesses. For these firms, it may make sense to prune out businesses when they reach maturity. Similarly, some businesses are great at turnarounds, but cannot add much value to an already successful investment. These firms may need to prune out businesses once they have successfully turned them around. By sticking to what one does best, one minimizes the risk of staying in businesses that no longer fit one’s strengths.

In addition, not all investments in the bundle will succeed. It is important to know when it is time to pull the plug on the losers.

Risk is an inherent part of creating business success. By utilizing strategic analyses and by understanding your strategic strengths, you can increase the chance of success within these risks.

If the only thing you add to an investment is money, then you do not provide very much to ensuring the success of the investment. However, if you add to that strategic insights and strategic synergies, risk goes down and likelihood of success goes up.

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