NOTE: THIS FIRST APPEARED ON HBR.ORG 5/5/16:
Risk is unavoidable. Whether we're driving in fast-moving traffic, arguing with a colleague in a meeting, or investing our hard-earned money, we are engaging in risk taking. As an investor, I think about financial risk a lot, and I've become interested in using the tools of the investor's trade in managing the large and small risks we face regularly. Those are:
Relying on knowledge and experience
Maintaining skepticism about predictions and promises
Let's see how the tenets might apply to three very different cases, each containing substantial risk.
Sara Campbell, a talented dress designer, sold the majority of her apparel as a private label supplier to national chains. When both Talbots and Laura Ashley collapsed in the financial crisis of 2008, Sara suddenly lost the vast majority of her revenues. Making matters worse, she was bound to fulfill contracts with manufacturers and suppliers despite the drop-off in client orders.
Steve Starr, the owner of Starr Real Estate in Austin, Texas, was worried that Eve, his commercial leasing manager, was becoming a problem. Eve was causing conflict with colleagues, taking excessively long lunches (from which she returned tipsy), and missing client appointments. When Steve took her to lunch near the office to discuss how things were going, he found out it was even worse than he thought: The restaurant manager called him into a back room to tell him he had good reason to believe Eve was selling cocaine out of his restaurant.
Christine, one of our clients at my asset management firm, wrote to Nicole, our director of customer service, saying that she was overseas and had found some fantastic antiques for which she needed us to wire a fairly large sum of money. Nicole assured her over email that we would transfer the funds immediately. Two minutes later Nicole received a new email from "Christine," asking for an even larger amount to be transferred for other "purchases." Nicole realized with horror that she had been duped. Christine's Gmail account had been hacked and we had been conned by a pro.
I interviewed Sara, Steve, and Nicole for my book, Even the Odds: Sensible Risk Taking in Business, Investing, and Life. How they responded to these risk-filled situations shows the power of right-sizing, right-timing, relying on knowledge and experience, and staying skeptical. Even if you can't control all four of these variables, controlling a couple of them can sometimes be enough.
For example, Sara had not recognized that she was violating the tenet of right-sizing by depending mostly on two customers. In addition, Sara and her partner, Peter Wheeler, had no control over the timing -- the economy was terrible, but there was no way they could wait for a better macro environment. They needed to act immediately to counter the triple threat of plunging sales, commitment to production capacity they didn't need, and very limited liquidity.
Relying on their knowledge and experience, they came up with a brilliant idea: Given the economic crash, commercial space could be leased relatively cheaply. They'd lease inexpensive space for Sara Campbell-branded boutiques to sell the clothing they were committed to producing. Although their advisers were suggesting bankruptcy, Sara and Peter borrowed from family and friends to fund the expansion. Their bet paid off. Today they have 13 Sara Campbell LTD stores up and down the East Coast and the business is more profitable than when they were primarily third-party providers. They used knowledge and experience to turn the terrible economic timing into a benefit.
Steve's case was a bit different. Sara and Peter had no control over the timing and no choice but to risk their whole business -- not ideal conditions -- but Steve had a flourishing business to protect. He used right-sizing and right-timing to mitigate the risk Eve posed.
When it sunk in that he had a big problem on his hands -- a dysfunctional and combative employee who was selling cocaine on the side -- he moved quickly. He told his attorney about the situation, and they agreed that Steve needed to dismiss Eve immediately. But there was potentially significant risk to Steve's reputation and his relationship with his clients if the whole messy story emerged.
They decided that because Steve could quantify several lapses in her work -- the combativeness, the missed appointments, and the absenteeism -- he could fire her without mentioning anything about her outside activities. Still, there was a risk she would try to sue. Steve and his lawyer decided it was a risk worth taking, since it was a smaller risk than either continuing to employ Eve or exposing the messy truth about her involvement with illegal drugs. And, indeed, when Steve fired her, Eve did sue for dismissal without cause and gender discrimination, but the attorneys settled the case quietly and without much pain.
In the case of my own business, there was no way to recoup the money. We contacted the FBI just in case, but they confirmed our fears: The money was gone. After I fully grasped that the money sent from Christine's account was gone, probably forever, it only took me a minute to decide what we should do. The reputational risk to our firm was very high. We knew we had to tell Christine right away and reimburse her the money, which was a meaningful amount. Despite that cost, it would have been both unethical and bad business policy to follow any other path.
I called Christine, filled her in, told her we were making her account whole, and apologized. She was extremely grateful that we acted so quickly, and she's continued to recommend us to other people. We've since changed our financial transfer policy to reflect a healthy amount of skepticism: We require a phone confirmation of any unusual transfer over $5,000, which is now typical across the financial services industry.
The tenets of sensible risk taking, right-sizing, right-timing, relying on knowledge, and remaining skeptical are useful as tools we can apply across business, investing, and life. Applying them mindfully will improve our risk-taking ability and lead to better outcomes, no matter what kind of mess we find ourselves facing.