Builders, bankers and risk aversion

In this, our last installment in a series of articles on builders and bankers, we’ll take a look at the relative attitudes toward risk of each group (and perhaps debunk some misconceptions in the process). You may recall that our use of the term “builders” refers to leaders who can build a hot fire out of a matchstick, and “bankers” refers to those leaders who can bank the coals to keep the fire at a consistent temperature. One group represents the entrepreneurs of the business world, and the other represents the steady leaders who keep the business going.

Our last article talked about the two groups’ attitudes toward risk, stating that builders tend to be risk-takers, and bankers tend to be risk-averse. But in reality, bankers will take risks in given situations: when faced with a loss. Thus they tend to be loss-averse, rather than risk-averse.

Consider this exercise devised by behavioral finance pioneer Amos Tversky:

• Choose from two alternatives with equal expected payoffs:
  • A certain gain of $85,000
  • An 85% chance of gaining $100,000 and a 15% chance of gaining $0

In both instances, the probability-weighted outcome is the same. However, the second alternative introduces uncertainty, and uncertainty equals risk. Most of us would take the sure thing rather than run the risk of ending up with nothing (unless one is a riverboat gambler or a contestant on “Let’s Make a Deal”). So we avoid uncertainty – risk – and thus we are indeed risk-averse, right?

Not so fast. Now, try part two of Tversky’s exercise:

• Choose from two alternatives with equal expected payoffs:
  • A certain loss of $85,000
  • An 85% chance of losing $100,000 and a 15% chance of gaining $0

This time, most people would opt for the uncertain outcome, willing to risk the additional $15,000 for the 15% likelihood of losing nothing (the numbers are important; this wouldn’t work with, say, a 50-50 chance on the outcomes, or a bigger spread between the maximum and assured dollar amounts).

The upshot of this, according to Tversky, is that we’re loss-averse, not risk-averse. When faced with a loss, we take on more risk in an effort to avoid or recoup the loss – sometimes to our peril.

Examples abound. Consider Nick Leeson, the former derivatives trader for Barings Bank, at the time the UK’s oldest investment bank. Leeson made a number of ill-advised trades in the early 1990s. Rather than follow the adage that one’s first loss is sometimes one’s best loss, Leeson hid the losses from his employer, and doubled his bets, hoping he’d be proven right at last, and that he’d at least recover the losses.

Leeson remained wrong, Barings failed, and Leeson went to prison.

Other infamous examples come from Societe General and Sumitomo, but we needn’t look to such high-profile cases for evidence of this stress-induced loss aversion. Closer to home:

• The homeowner who, finding that his mortgage balance is now more than the home is worth, walks away from the house – effectively buying high and selling low (i.e., taking the risk that the home’s value will recover, a virtual certainty) – not to mention assuming the high risk associated with destroying one’s credit.
• The 401(k) investor who increases exposure to equities because the market is rallying strongly, just the time she should be questioning valuations and diversifying out of stocks.
• Her counterpart, who bails out of equities following a spectacular crash, thus assuming the risk of missing the next upside by selling at the bottom (incurring opportunity cost, just another side of the risk coin).

All of these are actually examples of the type of behavior we’d typically see from bankers. Studies of serial entrepreneurs – builders – have found that they are willing to take risk, but only under two conditions: first, that their expected return is at least as high as the amount of their investment, and second, that they can afford to lose the amount they’re investing. The examples above may in some cases satisfy the first condition, but they certainly fail the second.

Applying this to the credit union context, we should be willing to take risk if we can be reasonably assured of earning a return on that investment, net of the outlay. However, a survey of 1,500 executives in 90 countries found that executives are extremely risk-averse regardless of size of investment. Executives turned down opportunities even when expected net present value was positive at a projected 75% loss level. Instead, they only accepted a risk of loss from 1% to 20% regardless of investment size.

This is decidedly banker-like behavior. Builders would invest in an initiative that returned positive value even at a 75% loss threshold.

To remain relevant and competitive, we as credit union leaders need to be willing to make those investments, to take those calculated risks. Enterprise risk management can be of benefit in assuring that we have the capital to do so, as we’ll explore in our next article in this series.

For more information about how enterprise risk management can benefit your credit union, contact Jeff Owen, Senior Consultant with The Rochdale Group, at (800) 424-4951, ext. 8011 or jowen@rochdalegroup.com.