The CEO’s Guide to Taking Risks

(Bloomberg Businessweek) -- Risky business, as every chief executive officer knows, is a redundant phrase. “To create value for shareholders, you inherently must take risks,” says Todd Gormley, an associate professor of finance at Washington University’s Olin Business School.

Although some CEOs embrace Alexander Smith’s notion that “everything is sweetened by risk,” arguably more favor Edmund Burke’s belief that “early and provident fear is the mother of safety.” Somewhere between lunatic risk-taking and paralyzing risk aversion exists a sweet spot of daring but prudent action. Finding this is as much art as science. Here are some tactics to help:

● ACKNOWLEDGE YOUR TEMPERAMENT

Even among CEOs, there’s a spectrum of risk-seeking to risk-avoiding personalities. “The perception is that CEOs, compared to the average person, are more likely to be risk-loving,” says Gormley. “But the data clearly shows that they also play it safe in many business settings.” For any leader, it’s important to know how your risk tolerance can bias your decisions, consciously or not. But understanding how your own temperament influences decisions can be difficult, says researcher Donald Hambrick, a professor of management at Penn State’s Smeal College of Business. “That’s one of the reasons for the burgeoning executive coaching industry,” he says. Another suggestion: Surround yourself with a leadership team of people with different dispositions who can serve as a sounding board—and are strong enough to disagree with you.

● EMOTIONS ARE YOUR FRENEMY

Conventional wisdom has long suggested that succumbing to emotion dooms rational deliberation. But as neuroscientist Antonio Damasio discovered in the early 1990s, emotion is essential to risk analysis. Damasio, a professor of psychology and neurology at the University of Southern California, studied patients with lesions in the emotional centers of their brains. The reduced influence of emotion didn’t render them coolly calculating, logical decision-makers like Star Trek’s Spock. Quite the opposite: These patients were unable to make even trivial decisions, such as what to eat for lunch.

Emotion is essential to handling risk, but that doesn’t mean it helps us make the right decisions. Studies show that anger makes men, though not women, more willing to gamble. It also makes both sexes less generous and more prone to impulse buying. By contrast, disgust increases risk aversion, an effect particularly pronounced in women. Decisions made in the throes of almost any strong emotion, from terror to optimism, most often lead to regret.

As researchers at University College London found, the key appears to be letting emotion flavor rational deliberation but not overwhelm it. Most of us know not to make important decisions in the heat of the moment—take a break, sleep on it, cool down. “Emotion recollected in tranquility” (William Wordsworth) isn’t just the key to poetry but also to sound judgment.

● NARCISSISM AND CAPABILITY CUES

External factors known as capability cues also exert strong influence on whether we’re likely to shoot for the stars or stay the course. CEOs are regularly barraged with feedback on their performance, from objective measures such as stock price to softer signals such as press coverage. These can raise or lower their self-confidence—and in turn affect risk-taking.

“For many CEOs, one of the most important aspects of personality is narcissism: an inflated sense of self coupled with a need to have that sense of self reinforced,” says Arijit Chatterjee, associate professor at Ecole Supérieure des Sciences Economiques et Commerciales. Hambrick and Chatterjee analyzed how objective measures and social praise influenced spending by 152 computer industry CEOs. As a proxy for risk-taking, they used measures such as research and development investment, and for risk aversion, how much a CEO was willing to overpay for acquisitions. The results: Objective performance measures had little effect on the confidence and risk-taking of more narcissistic business leaders, but media praise had a huge impact on their egos and belief in their abilities. By contrast, objective data mattered a lot to the less narcissistic, but media praise left them relatively unfazed.

The lessons seem clear enough. For narcissistic CEOs: Don’t let a glowing cover story, or hatchet job, turn you too cocksure or gun-shy. For non-narcissists: Don’t let recent performance, good or bad, knock you off your game.

● ALIGN PERSONAL AND COMPANY RISKS

Incentive packages, outside oversight, and job security factor dramatically into a CEO’s willingness to take or avoid risks. Gormley, along with David Matsa, a professor of finance at Northwestern University’s Kellogg School of Management, wanted to study why some CEOs, faced with the need to change strategies, stay the course rather than taking, as they put it, “painful-but-profitable choices like redistributing resources, enforcing pay cuts, or closing a plant and laying off dozens of workers.”

The most common reason, they discovered, was that it wasn’t in CEOs’ personal interest to do so, especially when their comp packages were heavy on equity. “When your wealth and reputation are all in one basket,” says Gormley, “the impulse is to protect yourself, even if it’s not in the best interests of the shareholders.” The latter can spread their own risk by diversifying; not so a CEO whose net worth is tied overwhelmingly to one company.

● SELFISH ACQUISITIONS

For companies facing serious threats, such as litigation or new regulations, a common risk-hedging strategy is to diversify through acquisitions. “It’s the same as an investor diversifying his personal portfolio,” Gormley says. A famous example is Phillip Morris International’s 1988 acquisition of Kraft Foods at a time when the health risks of smoking were becoming impossible to ignore. This might seem a prudent move, ensuring that even in worst-case scenarios, leadership will still have a company to run. But acquisitions are often less beneficial to ordinary shareholders, because their costs in added debt or dilution of equity outweigh any benefits. “If an individual is worried about risk,” says Gormley, “he or she can diversify for themselves at much lower cost. They don’t need the tobacco company to go buy other companies for them.”

Gormley and Matsa suggest several ways management can be more responsive to shareholders, from eliminating poison pill-style protections from potential takeovers to annual elections to ensure the independence of the board.

● PAYING FOR PRUDENT RISK-TAKING

Perhaps the most powerful tool is the structure of compensation packages for top leadership. It’s long been thought that payment heavy on company stock shares encourages strong performance because it hitches a CEO’s success to the company’s. In reality, Gormley says, equity can be a perverse incentive to play it safe and avoid risks. Stock options, on the other hand, encourage risk-taking because management is rewarded only when share prices climb. Just don’t go overboard loading up a CEO with options.

According to “Swinging for the Fences,” a study co-authored by Hambrick, when stock options constitute 30 percent to 40 percent of an executive’s pay package, it encourages not only more “swings” but also a favorable distribution of home runs and strikeouts. “Once you get above 50 percent,” he says, “the risk-taking becomes really careless and the outcomes become lopsidedly negative.”

To contact the editor responsible for this story: Dimitra Kessenides at dkessenides1@bloomberg.net

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