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Making Decisions Under Conditions of Risk and Uncertainty
Conditions of risk and uncertainty frame most decisions rendered by management.
Outline the various risks that influence the decision-making process
Uncertainty and risk are not the same thing. Whereas uncertainty deals with possible outcomes that are unknown, risk is a certain type of uncertainty that involves the real possibility of loss. Risks can be more comprehensively accounted for than uncertainty.
Decision-making under conditions of risk should seek to identify, quantify, and absorb risk whenever possible.
The quantity of risk is equal to the sum of the probabilities of a risky outcome (or various outcomes) multiplied by the anticipated loss as a result of the outcome.
A firm's ability to absorb, transfer, and manage risk will often define management's risk appetite; once risks are identified and quantified, decisions may be made as to what extent risky outcomes may be tolerated.
Uncertainty is a state of having limited knowledge of current conditions or future outcomes. It is a major component of risk, which involves the likelihood and scale of negative consequences. Managers often deal with uncertainty in their work; to minimize the risk that their decisions will lead to undesired outcomes, they must develop the skills and judgment necessary for reducing this uncertainty. Managing uncertainty and risk also involves mitigating or even removing things that inhibit effective decision-making or adversely effect performance.
One cause of uncertainty is proximity: things that are about to happen are easier to estimate than those further out in the future. One approach to dealing with uncertainty is to put off decisions until data become more accessible and reliable. Of course, delaying some decisions can bring its own set of risks, especially when the potential negative consequences of waiting are great.
Managing uncertainty in decision-making relies on identifying, quantifying, and analyzing the factors that can affect outcomes. This enables managers to identify likely risks and their potential impact. Types of risk include:
Strategic risks: These are risks that arise from the investments an organization makes to pursue its mission and objectives. They are often associated with competition and can include macroeconomic risks (the alignment of buyers and sellers consistent with the principles of supply and demand), transaction risks (the operational risks from merger and acquisition activity, divestitures, or partnerships), and investor relations risk (the risks associated with communicating effectively or ineffectively with the investment community).
Financial risks: These relate to potential economic losses that can result from poor allocation of resources, changes in interest rates, shifts in tax policy, increases or decreases in the price of commodities, or fluctuations in the value of currency.
Operational risks: These risks can arise due to choices about design and use of processes to create and deliver goods and services. They can include production errors, substandard raw materials, and technology malfunctions.
Legal risks: These risks stem from the threat of litigation or ambiguity in applicable laws and regulations (including whether they are likely to change); these threats create uncertainty in the steps an organization should take to address its obligations to customers, employees, suppliers, stockholders, communities, and governments.
Other risks: Risks are very commonly associated with force majeure, or events beyond the control of the organization. These can include weather disasters, floods, earthquakes, and war or other hostilities.
Once management has identified the appropriate risk category that may impact a certain decision, it may go about quantifying these risks. In other words, management will ascertain the costs incurred if a risky outcome were to happen. This can be mathematically daunting for many types of risk, especially financial risk. Generally speaking, however, risk is equal to the sum of the probabilities of a risky outcome (or various outcomes) multiplied by the anticipated loss as a result of the outcome. This is similar to performing a sensitivity analysis if the universe of outcomes is known.
The ability of a firm to absorb, transfer, and manage risk is critical in management's decision-making process when risky outcomes are involved. This will often define management's risk appetite and help to determine, once risks are identified and quantified, whether risky outcomes may be tolerated. For example, many financial risks can be absorbed or transferred through the use of a hedge, while legal risks might be mitigated through unique contract language. If managers believe that the firm is suited to absorb potential losses in the event the negative outcome occurs, they will have a larger appetite for risk given their capabilities to manage it.