Limits of Growth: Balancing Risks and Risk Appetite

The pursuit of growth and the creation of business value are key objectives of management in any organization. This often involves seeking out new opportunities, which come with inherent risks that must be carefully considered. Despite efforts to mitigate these risks, it is important to recognize that there will always be residual risks that cannot be completely eliminated.

One crucial insight to consider is that while each individual investment opportunity may align with the organization's risk appetite, the cumulative risks associated with multiple opportunities may eventually exceed this threshold. In such cases, it becomes necessary to make a decision: either refrain from pursuing additional opportunities or reassess and potentially increase the organization's risk appetite.

Interestingly, while it may seem logical for executives to reject new opportunities when aggregated risks become too high, this practice is not commonly observed. This reluctance may stem from a lack of clear direction or support for making such counterintuitive decisions. Additionally, the failure to quantify the organization's risk appetite and conduct a thorough quantitative assessment of the risks posed by new opportunities only perpetuates this status quo.

Various organizational factors, such as structure, governance, and culture, can also influence decision-making in this context. While these "soft" factors can be just as challenging as the quantitative aspects, the focus here is on addressing the latter.

It is important to recognize that even large companies, often perceived as having a higher risk appetite than smaller firms, may have their risk tolerance constrained by budgeting processes and performance expectations, particularly in the case of publicly traded entities.

To illustrate this point, imagine a scenario where a company builds a growing portfolio by investing in a series of similar projects with identical risk-return profiles. As more of these projects are added to the portfolio, the cumulative risk increases, eventually reaching a point where it may no longer align with the organization's risk appetite.

Suppose that the first opportunity has 5,000 as positive outcome and 2,500 as a negative outcome with 50/50 chance of landing on one of those scenarios. The Expected Value (or Probability weighted average) for such:

EV = 50% x 5,000 + 50% x (-2,500) = 1,250.

As the business is seeking growth, more similar opportunities are added to the portfolio.

For 10 opportunities, the EV of the portfolio can be 12,500 with more opportunities

Although this sounds to be very impressive, it is important to realize that the more opportunities are added to the business, the more risk the business will be exposed to.

Growing Portfolio of Projects

Risk Adjusted Portfolio Value

In fact, depending on the Quantified Risk Appetite (QRA) and the number of opportunities taken, this business portfolio might not be optimal for all companies.

It is possible to spot on the graph below, the optimal portfolio volume depending on the risk appetite of the business.

Risk Adjusted Business Portfolio Value

A risk averse company may show an optimal number of opportunities up to 8 projects while a less risk averse company may be able to handle more opportunities

In conclusion, striking a balance between seizing new opportunities for growth and managing risks effectively is essential for sustainable business success. By understanding the limits of growth and being willing to make tough decisions when necessary, organizations can ensure that they stay within their risk tolerance boundaries while continuing to drive value creation.