What is calculated risk in business?
Calculated risk in business is defined as, “…a carefully considered decision that exposes a person to a degree of personal and financial risk that is counterbalanced by a reasonable possibility of benefit.”1
All business owners have assumed some form of risk on the path to building their business. And risk doesn’t stop when the business gets off the ground. Business owners constantly need to assess risk as it relates to their offering, but also in context of growth and success. So how do you know if a risk is worth it?
Several factors go into taking calculated risks – numerical calculations, your deep expertise in your industry, and your own personality. You must bring all those factors together to get the most out of your decisions. Learn more about risk management.
Risk management is essential for small businesses
Entrepreneurs are, in part, defined by their willingness to take risks. Risks aren’t necessarily things you’re afraid of. Risks that pay off can lead to increased revenue, business expansion and more. But a good entrepreneur doesn’t take risk without knowing what’s at stake and what the potential payoff can be. This concept is called the risk-return tradeoff.
Forbes describes risk-return tradeoff as the “bedrock of modern investing.” While the concept is most often associated with stock investors, the truth is that owning a business isn’t very different from playing the stock market.2 At their core, both are about risk management — which is where the risk-return tradeoff comes in.
The risk-return tradeoff is an examination of what you stand to lose against what you stand to gain. It includes calculations of risk, but also requires you to apply all the information you know about the market you’re working in, your customers and your general business climate. Think of it as mostly calculations with some informed instinct in the mix.
For most people, thinking about the risk-return tradeoff will force them to step into an uncomfortable mindset because people tend to crave security. However, many entrepreneurs already possess the personality traits that make them more likely to step outside of their comfort zone. They tend to be more excited by the idea of the unknown and therefore more comfortable with assuming risk. But before making any decisions, you need to determine your own comfort level and set it as a benchmark for how much risk you’re willing to take.
How much risk is too much?
There are a few common pitfalls to calculated risk. One is assuming more risk than you can manage. There isn’t a set number that defines a good level of risk because it varies from person to person. To determine how much risk is too much for you, you should start by establishing your risk appetite, risk tolerance and risk thresholds.3
- Risk appetite: The degree of uncertainty you’re willing to accept in anticipation of a reward
- Risk tolerance: How much risk you can withstand before the reward
- Risk threshold: The point at which the risk is no longer worth it for the reward
Risk appetite cannot be quantified. It usually shows up in your business’s culture. You have to decide if you are willing to live in that uncomfortable space and allow for risk or if you would rather be more conservative in your risk taking. From there, you can establish your risk tolerance.
Risk tolerance is the measure of exactly how much negative affect you can allow from your decision. For instance, a business owner may choose to make a change that means their product will take longer to produce, but will result in a higher quality end-product that will sell more units as a result. Their risk tolerance is the added time it will take in production.
Lastly, the risk threshold is the point where the reward has been cancelled out by the risk. You should quantify your risk threshold with an actual dollar amount that serves as an indication of when the risk has not paid off. For instance, you may choose to say that at $10,000 of loss, the reward is no longer worth pursuing.
Determine risk by conducting a risk versus reward calculation
A risk calculation is a great place to start as you determine whether a risk is worth it. Risk is calculated by dividing the net profit that you estimate would result from the decision by the maximum price that could occur if the risk doesn’t pan out.4 Compare the resulting ratio against your risk tolerance and threshold to inform your decision.
For example, if you know that installing a new piece of equipment will cost you $100, but believe that it will result in $500 more in revenue due to increased efficiency, you would divide $500 by $100 and find a risk/reward ratio of 5:1. Is that within your risk tolerance? If so, you can more confidently move forward with the investment.
Risk isn’t the same as luck
Sometimes people mistake risk for chance. They see successful entrepreneurs and attribute at least a portion of their success to luck. But calculated risk is about just that — calculations. It’s careful analysis of what you stand to gain against what you could lose. The best entrepreneurs and business owners leverage calculated risk to grow their businesses and inform their decisions by taking luck out of the equation.
By combining risk versus reward calculations with your knowledge of the business climate in which you exist, you can eliminate much of the unknown and move forward with riskier decisions with a more informed mindset.