How Short-Term Thinking Affects Risk Perception, Investment Decision-Making and the Need for Business Activism

Business managers likewise are preoccupied with the short term. As a result they don’t concern themselves with risks that they perceive as longer-term, or risks whose probability of occurrence they underestimate out of ignorance.

What is a business risk? Something that has a potential negative impact on the organization’s performance or sustainability (its ability to continue to operate and meet its objectives indefinitely). Risk is the product of (a) the probability or frequency of an adverse event occurring and (b) the severity of consequences (financial or otherwise) if it does occur. On the charts in this article, high risks are those in the upper right corner.

Risk management is the awareness, preparedness and mitigation actions an organization takes to minimize the consequences of organizational risks.

The charts above and below each display 30 major types of organizational risk.

• The top chart (#1) shows these risks as they are perceived by management in the short term — the next five years (based on three recent surveys of business and financial executives).
• The middle chart (#2) shows these risks in the short term according to my recent research. The four groups of risks in yellow are shifted up and to the right in chart #2 compared to chart #1. In my opinion, managers are significantly underestimating these risks to their organizations.
• The lower chart (#3) shows these risks over the longer term (the next 20 years) according to my recent research. Six groups of risks are shifted from the upper centre to the upper right in chart #3 compared to chart #2. These six types of risks are all likely to occur inevitably — the question is whether this will happen sooner, or later. 

These charts show, in italics, the steps most organizations take to try to prevent, mitigate, plan or prepare for each of these types of risk.

• Those shown in orange are mitigated risks — management considers their probability to be low but the consequences if they occur to be high. They therefore try to prevent or ‘head off’ such risks.
• Those shown in green are insured risks — management considers their probability to be high but the consequences if they occur to be low. No point trying to prevent them if they’re almost inevitable, so they try to detect and/or insure against them.
• Those shown in blue are the risks that keep managers awake at night. They have relatively serious consequences if they occur and a relatively high probability of occurring. They are too expensive to insure and difficult to mitigate, prevent or detect.
• Those shown in yellow are underestimated risks. The asterisk beside them indicates that management in most organizations does nothing to address these risk, either because they think they are remote (perceived to be in the lower left quadrant) or because they don’t think there is anything they can do to address them.

These charts suggest that most managers are ignorant of some significant risks their organizations face. Public health experts tell us a pandemic is a virtual certainty in the next generation, and could occur anytime, and one of the lessons from SARS is that, even if the death and illness toll of a pandemic is modest, its economic cost will be astronomical. And, probably not surprisingly, the charts show that managers think short term, not long term. As long as analysts are focused on the next quarter’s earnings, that is unlikely to change. Long term thinking by management is simply not rewarded.

So if you’re an investor, what should you make of this? My suggestion is that you do your own assessment of risks facing the companies you are thinking of investing in, and then read the Management Discussion and Analysis to see (a) whether what management is doing to address those risks is appropriate, and (b) to the extent there is little management can do, how exposed the company is to risks beyond its control.

And if you’re an activist, how can you use corporate management’s risk preoccupation to bring about social and environmental reform? This is tougher, because you need to discover what most companies don’t disclose: the social and environmentally irresponsible activities they engage in: the pollution and waste their operations produce, their propensity to use outsourcing, offshoring, union-busting and unsafe labour practices to keep costs down, the extent to which they intimidate employees and customers seeking redress for corporate misdeeds, their lobbying activities that are in the company’s interest but against the public interest, and the exploitation of foreign labour and underpriced foreign resources..

Most of these activities, while unethical, are not illegal. What’s worse, because they externalize costs (transfer them from the corporation to others) these actions contribute to the Tragedy of the Commons — and therefore exacerbate many of the external risks on these charts (global warming, energy and water shortages etc.) — risks that then affect everyone on the planet.

Because these activities are not illegal, and many of them increase short-term profits, the activist’s only recourse is to educate the public and embarrass the company into behaving more ethically. They will do this if public outrage reaches the level that the risk of damage to its reputation (one of the risks in blue on these charts) exceeds the financial rewards of unethical behaviour. Many pension funds, government investors and other private equity funds now consider corporate ethics in making investment decisions, and a combination of customer and investor loathing for a corporation’s behaviour can be a powerful market force, and a motivator to a company to clean up its act. As consumers and investors, we have more power to influence corporate activity than we might think. But it’s very difficult and expensive to get compelling, reliable evidence of corporate misdeeds, in an age when the mainstream media have largely given up on investigative reporting, and when giant corporations have deep pockets and armies of lawyers to buy off or threatenwhistleblowers, activists and investigative journalists.

But at least we can know what motivates management thinking, and therefore what we’re up against.