No risk, no reward? Not necessarily...

In our competitive culture "no risk, no reward" is an axiom. But is all risk the same? In their new paper, "Not All Risk Taking is Equal: Firm Performance and the Motivation for Executive Decisions," Nathan Washburn and co-authors studied the risk-taking behaviors of executives. They found that the real question facing executives is not whether to take risks, but what kinds of risk to take. "What we ended up accomplishing was to present a new perspective on executive risk taking," Washburn says.

It's an idea that has long been a guiding principle for investors — not to mention poker players, race car drivers, rock climbers, rodeo cowboys and just about anyone else who lives on the edge. Somewhere along the line, though, that "risk-is-good" mantra also became something of a guiding principle for executives. And Nathan Washburn can't help but wonder if that's a bad thing. Washburn, who is finishing up his Ph.D. in management at the W. P. Carey School of Business, looks at risk somewhat differently than other business researchers.

Recently, he joined two colleagues — management professors Luis R. Gomez-Mejia of the W. P. Carey School and William H. Glick of Rice University's Jones Graduate School of Management — in a research project that challenges long-standing assumptions about executive decision-making, the motivations that push managers to take risks and, most crucially, the idea that more risk is better than less risk. "As I read through these basic arguments [about the value of increasing risk taking], it didn't sit right with me," Washburn says.

"It seemed that not all risk taking is the same. Some kinds of risk taking might be beneficial, but other kinds of risk taking would actually harm a business." To Washburn's way of thinking, the old theories don't work for one reason: They treat all risk taking as if it is the same. While he agrees risk taking may sometimes be a good thing, he doesn't believe — as other theorists do — that the quantity of risks taken is nearly as important as the quality of those risks.

It sounds simple, but Washburn says "quality" of risk has never really been considered in the risk taking literature, nor has there been thorough examination of the differing pressures and situations that may lead some executives to take good risks and others to take imprudent ones. In their new paper, "Not All Risk Taking is Equal: Firm Performance and the Motivation for Executive Decisions," Washburn and co-authors hoped to make "a statement about risk taking and the problems that exist with the risk taking literature."

They write: "the real question facing these executives is not whether to take risks, but what kinds of risk to take." "What we ended up accomplishing was to present a new perspective on executive risk taking," Washburn says. "We wanted to point out that if you examine risk taking only from a 'How-much-are-you-going-take?' perspective, this places an emphasis on the wrong thing.

Firm policies and practices designed to encourage executive risk taking could actually encourage more 'imprudent' risk taking rather than more 'good' risk taking. By focusing on risk taking quality, we were able to differentiate the conditions that could lead to 'good' vs. 'imprudent' risk taking."

All risks are not equal

So where does the idea that all risk is good come from, exactly? "The finance literature has suggested that there's a positive relationship between risk and profit," Washburn says. "We've sort of accepted [the idea] that the more risks you can take, the more a company will be rewarded by the market. This idea (that more risk taking is better) is strengthened by the belief that managers are risk averse, thus they don’t take all the risks they should.

Managers have all their eggs in one basket, but shareholders have their eggs in many baskets. While the shareholders want [products] to arrive very quickly, the manager is walking very carefully with those eggs, because if that basket falls, it's all the managers have got." Built on these two beliefs, it appears that one problem facing businesses is to encourage executives to take more risks.

Some theorists believe so strongly in the "more-risk-is-better" theory that they propose that companies craft compensation policies that will encourage executives to take more risks — with the idea being that more risks can produce better results. But Washburn and his colleagues write this idea is "flawed," simply because "increasing risk is no guarantee" of ultimate bottom-line success.

The perspective we’re proposing is that not all risk-taking will lead to increased performance.

— Nathan Washburn, Ph.D. candidate in management

Washburn uses the following example to make his point: Imagine a company getting ready to launch a potentially exciting and profitable new product. The manager overseeing the project is not likely to allow that product to hit the market until he or she is fully convinced that the product is ready for launch. Investors, however, might see the value in getting the product out as soon as possible.

Such a move could give the company a jump start on its competition, create short-term earnings and, maybe most importantly, produce a quick payday. In this scenario, investors may see a manager's cautious approach — even if it is a logical one — as an impediment to profit. And because those investors likely have an interest in several companies that are on the cusp of launching several exciting products, they aren't nearly as worried about the failure of just one product, or the disgrace of one manager.

But a rush to market that might be good for investors is not necessarily the right move for an executive or the company he/she is managing. It's a dynamic that can pit the interests of investors against the responsibilities of managers — and Washburn says that's not a good place for executives to be.

"By suggesting that, in general, managers need to take more risks, we are encouraging these managers to run really fast with their basket of eggs. But maybe we're not just encouraging them to run fast," Washburn says. "Maybe we're encouraging them to run recklessly fast.

Vantage point impacts risk taking

Common sense suggests the investors' point of view doesn't tell the whole story, Washburn says, and the rest of the story comes down to quality. According to the team's theory, there is very big difference between good risks and bad risks. And the difference may most easily be seen, they say, by examining the differences in decisions made by executives in high-performing firms and low-performing firms.

The team proposes that different motivations can lead executives in different situations to take risk of vastly different quality. In other words, while executives in underperforming firms may be more willing to take any kind of risk — what do they have to lose? — leaders at high-performing firms will naturally be inclined to be more selective about what bold moves they should make. Washburn says that's not a bad thing.

"Simply risk taking is not the goal," he says. "You've got to increase the good risk-taking." Executives at high-performing firms, driven by a "general contentment" with their capabilities and resources will be careful, taking risks that are linked to and wisely utilize their resources and capabilities. That's a practice that managers at low-performing firms may be less likely to engage in. Motivated by discontentment and "desire for alternative option outcomes, these executives will be more likely to seek out risks that help them escape from their current resources and capabilities."

In short, the team says that while it's likely the latter executives will take more risks, they probably also take more reckless ones. Obviously, these are risks that aren't necessarily grounded in good sense. "What we argue is that in a lower-performing context, executives will be driven to take risks because they're in a desperate situation," Washburn says. "They want to escape from what they have, so they look out there [in the marketplace] and see a lot of attractive alternatives. When you're in a bad place, a lot of things look better — that's low-quality risk taking."

Washburn says he knows the paper flies in the face of current risk theory, but he and his colleagues also believe the work holds great promise. If companies, boards, executives and even investors better understand the dynamics of risk, they may be better equipped to shape everything from executive compensation packages to corporate law to public policy. Eventually, Washburn says, the risk-is-good crowd might come around to the simple idea that a mantra that works great for a poker player or NASCAR driver might not be the best principle for a corporate executive.

"I think this is pretty different from what's out there," Washburn says. "When you look at how [risk] has been written about and studied, it's been all quantity. Just: How much? If you just plug in another idea into the equation — quality — it changes a lot of things. And I think most people would say, 'Oh sure, that makes sense.'"

Bottom line:

• Some theorists believe executives should take more risks because doing so can produce more profits, and the idea has led some companies to craft executive compensation policies that encourage risk.
• But, it's possible that it's not the quantity of risks taken that matters, but the quality.
• While executives in low-performing firms may be motivated by "discontentment" to take more risks, executives in high-performing firms are less likely to make foolish moves and take only the risks that make strategic sense.
• A better understanding of when risky moves are good could help improve company performance and lead to smarter policies about corporate governance and executive compensation.