Part two in a three part series by Dr David Hillson and Ian Huntly, CEO of Rifle-Shot Performance Holdings.
We have seen that risk appetite is an internal tendency within an individual or a group and that it cannot be seen or measured directly. It represents a hunger for risk in a given situation, a desire or drive to take on a certain level of risk exposure. But where does this internal tendency comes from? What influences risk appetite?
One obvious input to risk appetite is the situation that is being faced. Risk appetite does not exist in a vacuum or in isolation. It is defined as “tendency of an individual or group to take risk in a given situation”, so clearly that situation is influential.
In fact it is not just the situation in general that influences risk appetite, but the specific objectives that an individual or organisation wishes to achieve in or from that situation. For a project manager, the situation is the project, and the objectives are the project objectives.
In addition to the situation and its associated objectives, there are two other factors that influence risk appetite. Both of these are to do with people, which is unsurprising since risk appetite is an internal tendency. The first factor relates to individuals and the other arises from the group context:
* On the individual side, the appetite for risk in a particular situation is affected by the general tendency of each individual to take risk in any circumstances. This is called risk propensity, and it in turn is driven by a range of risk-related personality traits, or innate motivations, known as risk preferences.
* Another influence on risk appetite is the culture of the group or organisation in relation to risk, describing the set of shared beliefs, values and knowledge that a group has about risk. This is called risk culture, and it results in a set of norms and behaviours that are naturally adopted by the group when situations are faced that are perceived as risky and important.
One interesting fact to notice about these inputs to risk appetite is that they are all internal and they are not chosen by the individuals separately or the group acting together, they just are what they are. The effect of individual risk propensity and corporate risk culture on risk appetite is subtle and invisible, it is essentially unmanaged, and it cannot be seen or measured externally.
The resulting risk appetite therefore arises unconsciously and without the deliberate choice or intentional intervention of the individual or group concerned. That is why we describe risk appetite as a tendency – because it is internal and unmanaged.
As well as considering the inputs that affect risk appetite, we should also look at its outcomes. Just as we have no units to measure or describe physical appetite, the same is true for risk appetite. We also need an external proxy for risk appetite, something that can be seen and measured objectively. This role is taken by risk thresholds, which are external expressions of risk appetite.
And just as risk appetite is defined in terms of the objectives associated with a specific situation, risk thresholds are expressed in the same way. There should be a risk threshold set for each objective, reflecting the overall risk appetite in the situation.
Once we have defined risk thresholds for a given situation (how much risk we are willing to take), we can then compare these with the overall risk capacity of the organisation to bear risk, either in this specific situation or in aggregate. This will tell us whether our risk appetite can be fully satisfied or not. We might find that our appetite for risk leads us to set risk thresholds that exceed our capacity to take risk.
This could lead to a problem if left unmanaged, since we might end up taking on too much risk, exceeding our risk capacity. Alternatively our risk appetite may lead us to be too cautious, setting low risk thresholds which are well within our risk capacity, and which do not stretch or challenge the organisation or make best use of its resources.
Considering inputs first, the chosen risk attitude is influenced by the perception of the degree of risk exposure associated with a given situation, and risk perception in turn is affected by a complex Web of factors, referred to as the “triple strand” of influences (conscious, subconscious and affective factors).
It is common to speak about only a few specific risk attitudes, such as risk-averse, risk-seeking, risk-tolerant or risk-neutral. But in fact risk attitude exists on a continuous spectrum with an infinite number of possible positions. Faced with a given risky situation, a particular individual or group might exhibit a risk attitude anywhere on this spectrum.
Turning to outputs from risk attitude, two things are important in the context of making decisions in risky and important situations. The first is that our attitude to risk affects the degree of risk we are willing to take, as expressed in risk thresholds.
Clearly if we are comfortable with the perceived exposure to risk (i.e. our attitude is risk-seeking) then we will wish to set higher risk thresholds than if we are uncomfortable with the uncertainty (risk-averse).
But the influence of risk attitude is much wider than simply affecting the chosen level for risk thresholds and tolerances – it also affects our risk actions. In fact every action we take in relation to the perceived level of risk exposure is driven by our position on the risk attitude spectrum. Each step in the risk process is affected by the risk attitude we adopt in the situation, including:
* Identifying threats and opportunities;
* Assessing and prioritising identified risks; and
* Selecting and implementing appropriate risk responses.
Our risk actions modify the degree of risk exposure associated with the situation, leading to a revised perception of risk. As a result we may wish to change our risk attitude, to give us the best chance of achieving our objectives in the light of the new risk challenge that we now face. So in fact there should be a cycle between the current level of risk exposure, our chosen risk attitude, and the risk actions we take.
Changing risk attitude is a simple matter of making a different choice. Earlier work (Murray-Webster & Hillson, 2008) has described how applied emotional literacy can be used to modify risk attitude in an intentional way, using a framework called the “Six As” model.
This starts with “awareness” of the existing risk attitude that we have initially chosen in a given situation, together with “appreciation” of the factors that have influenced that choice. Next we “assess” whether the risk attitude is helping us to achieve our goals or not.
If the existing risk attitude is assessed as being “appropriate”, then we “accept” it and continue without change. But if a change in risk attitude is required, then we “assert” the need for change and take “action” to modify our chosen risk attitude.