Risks are often thought of as largely compartmentalized, independent threats to business strategies and initiatives. While this viewpoint makes risks easier to categorize in the abstract, out on the streets of reality risks are often highly dependent, with the materialization of one risk setting in motion other seemingly unrelated risks. Risk interdependence leads not only to isolated risk events but rather to highly dynamic, unpredictable and damaging risk chains.
Risk Independence
When developing a business strategy or analyzing a potential business initiative, it is very common to not only list the initiative’s strengths but also the key risks that could prevent the strategy or plan from being successfully implemented. These risks might include market risks (such as the risk that demand for a product or service will be less than expected), operational risks (such as the risk of a lack of qualified people to implement a business plan) or regulatory risks (the risk that changes to laws or regulations will negatively impact the viability of a project).
While actively trying to identify potential threats to a business initiative is wise, when scanning the business environment for potential roadblocks there is a tendency to view risks as falling into separate, unrelated areas. Market, operational and regulatory risks are typically thought of as having very different causes, developing along different paths and impacting businesses from different directions.
The same analytical tendency applies to specific project risk factors. To take a specific example, when reviewing a potential residential real estate project a real estate company might list the following risks:
- lack of demand for the project
- lack of funds to complete the project; and
- lack of qualified personnel to manage the project once it is developed.
Once these risks were identified, the real estate company might then consider the probability of each of these risks materializing and the economic impact of the risks if they do materialize. If the company targets managing 100 units at a rent of $1,000 a month if a lack of demand causes rents to fall to $900, the economic impact of the risk is $10,000 a month.
A lack of qualified people to manage the project may cause service levels to fall, which in turn could affect rent levels. If we assume that low service levels will cause the rent that can be charged to fall to only $800 a month, the potential economic impact of the risk is $20,000 a month.
The key thing to note in this approach is that each of the risks is considered to be independent from the other. This is in fine in the abstract but lurking just out of sight is riskasaurus.
Risk Interdependence and Risk Chains
While a business and economic worldview where risks are independent is attractively simple and sounds reasonable, it often does not paint a realistic picture of how risk events actually play out in our highly complex, dynamic and interconnected world. Rather than existing independently, it is more often the case that risks are highly interdependent, with one affecting the other in ways that can be very difficult to forecast.
To return to the above real estate example, if there is a lack of demand for a real estate project it will not only impact the ability of a real estate company to attract financing but also will likely affect the chances of the real estate company to hire highly qualified people to manage the real estate project. The lack of qualified people may reduce even further the chances of obtaining funds for the project. This interdependence of risks and its ability to generate increasing damage can be thought of as a risk chain.
Key elements of risk chains are:
- they are triggered by other risks
- they have the ability to trigger other risks events
- they are often non-linear and grow exponentially
- they have the ability to jump to new areas, such a medical risk becoming an economic risk or vice versa; and
- they have the ability to rapidly accelerate or decelerate. The acceleration of a risk chain can very quickly cause a large amount of damage.
Managing Risk Chains
As difficult as it is to handle single risk events, managing risk chains is much harder due to how quickly they can escalate and how fast their destructive paths, like the tail of a ferocious monster, can move from one direction to the other, harming what lies in their way.
Taking four steps can help defend against risk chains and even create opportunities to turn them in advantages.
A Risk Chain Perspective. The first way to approach the management of a risk chain is to view risks as interdependent rather than independent. Taking this perspective allows us to develop downside business scenarios that contemplate negative consequences that accelerate and expand in a non-linear way rather than remaining fixed or expanding at stable rates. Approaching risk analysis from this vantage point can help businesses realize that that they can be pushed into very precarious operating scenarios much faster than they might have otherwise thought and take appropriate defensive measures.
Risk Chain Resistance. Risk chains pose the greatest threat to businesses that have the least ability to resist risk events due to their business model, operational supply chains or available resources. Because of this, when businesses contemplate growth strategies they should not only consider maximizing revenues within a narrow vertical but expanding their overall base of revenues. This may not lead to the generation of the greatest amount of revenues possible in the short term but can create a stronger risk chain defense.
Risk Chain Anti-Fragility. A third way to manage risk chains is to develop a business plan and adopt a posture of business agility which is not only harmed by risk chains but can actually benefit from them. For example, a risk chain which harms the real estate market and forces down prices can also create advantages for developers who are looking to buy land at a reduced price that they can develop in the future. This can leave a developer in a better competitive position once the risk chain passes and general real estate demand rises again.
Risk Chain Perspective. A fourth approach to managing risk chains is something that sounds easy in the abstract but can be very difficult in practice: not taking steps that make things worse.
My first Chinese teacher used to say to me, “If you make one mistake, you make two mistakes.” While this may sound like a philosophical over-generalization, in fact it is often true because once you make a mistake it often changes a number of things, including your attention, emotional state and overall frame of mind in a way that makes additional mistakes more likely. If I make a poor shot in tennis, I may begin to berate myself for making the error, which takes my attention away from the next shot, causing a second error. With each mistake, the probability of additional mistakes rises.
As there is a tendency for risks to lead to reactions which can compound them, if one can remain in a state of calm as risks start to materialize and not get drawn into them, it becomes more likely that one can avoid taking actions that will aggravate the risks further. Additionally, keeping an analytical and emotional distance from the destructive power of risk chains can allow us not only to take the best steps possible under the circumstances but even to see if there are ways to benefit from the consequences that risk chains are creating.
Conclusion
The fact that risks are highly dependent and can affect and cause the spread of each other in ways that are hard to predict requires a flexible approach to risk management. While no risk management strategy can completely eliminate risk, striving to see the relationships between potential risks, trying to build businesses that are not only harmed by different risk events but can even benefit from them and setting up measures to minimize the likelihood that the damages from risks once they materialize will escalate can leave businesses much better prepared for the unknown.