Is it time to rethink risk and reward?

“It is important that we guard against becoming too risk averse. I understand that in an uncertain world, it can be hard to take on risk and there can be a natural tendency to avoid new risks. But, if businesses are to seize the opportunities that are out there to grow and to increase Australia’s productive capital base, some degree of risk taking is necessary,” Dr Phillip Lowe, Reserve Bank governor.

Speaking at the recent CEDA Annual Dinner, Dr Lowe, urged businesses to take advantage of current low interest conditions and seek to benefit from the many opportunities that will emerge over the coming years.

However, this can be easier said than done. There is still a high degree of uncertainty (which is likely to remain) and the events of this year have created a heightened sense of risk aversion amongst many boards and executives.

Many organisations also find themselves in a position where the risk landscape has changed, and they no longer have an appropriate balance of risk and reward.

So, how can organisations take up Dr Lowe’s suggestion and seize the emerging opportunities? The answer is to consider the risk reward curve and how the organisation can change its positioning on that curve.

Risk and Reward

It is well understood that there is a relationship between risk and reward. In general, higher rewards come with greater risk. Similarly, taking on little risk is likely to produce limited returns. This relationship will not change as we come out of recession and the impacts of the pandemic. However, what has changed is the positioning of the curve.

Many organisations will find they now face increased risks but are expecting the same returns. For example, retail is experiencing increased levels of online shopping and home delivery, which is increasing competition. Those retailers continuing to only offer a bricks and mortar experience will find it hard to drive greater returns in the face of increased risk from online competition.

Similarly, other organisations may find risks are similar but returns have decrease. For example, tour operators will face many similar operating risks, however with reduced tourism and travel will find it difficult to operate at full capacity, leading to reduced returns.

In the face of this changed landscape, boards and executives need to consider how they can shift the organisation to a better risk reward position. The diagram below shows there are four possible approaches to making this shift.

The four approaches are:

1. Reduce risk. The first approach is to simply adopt more stringent risk management techniques to reduce the level of risk whilst maintaining reward. This approach may have some appeal as it can be relatively easy for the board to focus on one area (risk) to direct and coordinate efforts. However, it is unlikely to be fully effective as not all risks can be reduced through management without also impacting returns. In the retail example above, reducing the risk of sales volume lost to online trading would likely come at the expense of reduced pricing.
2. Increasing reward. The second approach is to seek to increase reward for the same level of risk. This requires a strategic planning approach to consider alternate markets for existing products or services or, alternatively, developing complimentary products and services. Again, this may have some appeal given its focus but may also change the risk landscape. For example, the retailer could commence online trading, however this creates a range of new risks around technology, stock control and distribution.
3. Combination. To effectively move from the current position and adapt to the changed risk reward landscape, boards and executives will need to implement a combination of the first two approaches. They will need to deeply consider the changed landscape and possible future scenarios to identify strategic opportunities and emerging risks, implement appropriate risk management techniques and adjust to a new risk reward relationship.
4. Strategic transformation. For bolder or more entrepreneurial boards, emerging from the current environment will present opportunities to transform the organisation or even their industry. For some, there will be the possibility to create an entirely different organisation that fundamentally shifts the risk reward relationship – potentially leading to much greater returns.

Boards have an important role in driving organisational value, which in turn results from an appropriate balance of risk and reward. As Dr Lowe pointed out, there will be a number of significant opportunities emerging over the coming months and years. Careful consideration of risk and reward in harmony in the current and future context will provide boards and executives with the foundations required to take advantage of these opportunities.