Risk and reward are inseparable and a basic fact of business—as well as life. But not all risks are equal. We approach risks involving human safety differently from those associated with the margins in a multi-year contract. Our goal is to make risk decisions in a manner consistent with our principles. This encompasses eliminating catastrophic risks – like those that could lead to a potential loss of life or a major environmental issue – and optimizing other risks.
Before pursuing opportunities, we seek to understand their risks and potential rewards and then determine whether to absorb, mitigate or avoid those risks. As employees, we are expected to apply Koch’s risk philosophy, not our own.
Applying the company’s risk philosophy can be especially difficult when you are making financial decisions. Koch’s substantial resources enable it to undertake far greater and larger financial risks than you would yourself. Suppose you have two opportunities that require the same investment. One has a 90% chance of making $100,000 and 10% chance of making nothing. The other has a 50% chance of making $1 million and a 50% chance of making nothing. On a risk-adjusted basis, the expected value of the first opportunity is $90,000 and the second is $500,000; therefore, you should pursue the second opportunity. Although you only get a positive result for Koch 50% of the time, it is the right decision. It is natural to settle for the safer alternative but doing so leads to an unsatisfactory return on capital and makes Koch less profitable over time.
One challenge in motivating good decision making is the principal/agent problem. This tends to be created whenever a principal (owner) hires an agent (employee, consultant or broker). The principal wants the agent to act in the best interest of the principal, while the agent usually wants what is best for the agent.
Consider what can happen when the principal and the agent have different risk profiles or incentives. Sometimes agents play it safe because there is no personal upside to taking appropriate risks. Incentives discourage prudent risk-taking when they fail to reward optimal outcomes and excessively penalize losses. Conversely, agents may take unauthorized or imprudent risks when there is not much personal downside. In such situations, agents “go for broke.” Entire companies have been destroyed as a result of this problem. Even so, we don’t want to create a rule-based, overly cautious culture. We seek to align the interests of all employees and agents so they will make decisions that maximize the long-term success of the company.
Good risk-adjusted decision making also involves avoiding various decision traps. These predictable, systematic failings in judgment affect us all. One of the most serious and frequent is confirmation bias, which occurs when we preferentially look for evidence that supports what we want to believe and ignore or discount evidence to the contrary. This particular trap led to our disastrous acquisition of Purina Mills in 1998.
To help us avoid decision traps and appropriately address risks in our decisions and actions, our approach includes:
- Building a strong culture and capabilities to avoid catastrophic risks and minimize disruptions from incidents (stewardship).
- Engaging others with diverse experience to challenge our assumptions.
- Developing realistic scenarios for a sufficiently wide range of potential outcomes, recognizing that we cannot perfectly predict the future.
- Establishing measures to monitor progress and creating options so adjustments can be made as needed.
- Experimenting on an appropriate scale rather than diving in without proper analysis (plunging).
- Not letting prior losses or a leader’s initial rejection prevent consideration of a good opportunity.
- Recognizing the uncertainty in our investment assumptions, which are greatest for those farthest out, such as the large risks in long-term price and terminal value assumptions.
Accounting for the improvements our competitors will probably make when projecting our own improvements.
Risk and reward cannot be our only criteria for evaluating opportunities. We apply our principle-based framework to ensure that we have the capabilities to make an opportunity successful long term. This includes considering its opportunity cost – not just whether it will be profitable, but whether it will provide a higher return on capital and other resources than alternative opportunities.