Jayashantha Jayawardhana shows how to mitigate risk

Even as we extol the virtues of innovators, and emphasise the need for product and service innovation, the process involves an element of risk. The risk of an innovation depends largely on the choices people make when using it.

In an article in the Harvard Business Review (HBR), economist and Nobel Laureate Robert Merton writes: “Ask yourself this; if you had to drive from Boston to New York in a snowstorm, would you feel safer in a car with four-wheel drive (4WD) or two-wheel drive? Chances are that you’d choose four-wheel drive.”

He continues: “But if you were to look at accident statistics, you’d find that the advent of four-wheel drive hasn’t done much to lower the rate of passenger accidents per passenger mile on snowy days. That might lead you to conclude that the innovation hasn’t made driving in the snow any safer.”

But is this conclusion correct?

What happened isn’t that the innovation of 4WD has failed to make passengers safer but people have changed their driving habits because they feel safer. Now more people are venturing out in the snow than previously and are probably driving less carefully into the bargain.

More vehicles being driven a whole lot faster in the snow would expose passengers to the same or an even higher degree of risk than if the number of vehicles being driven in the snow and their speed remained the same as prior to the advent of 4WD. The risk of accidents would be much lower in comparison.

Merton observes that if the risk of an innovation depends on the choices people make, it follows that the more informed and conscious their choices are, the lower the risk will be. He says that to minimise risk and unintended consequences, users, companies and policy makers need to understand how to make informed choices when it comes to new products and services. He offers five rules for them to follow.

MENTAL MODEL Realise that you need a model. When you adopt a new product or technology, your decision about risk and return is informed by what cognitive scientists call the ‘mental model.’ Returning to the 4WD example cited earlier, you may realise that of the many elements of risk associated with the journey, you can only control the type of car you use and the speed at which you drive it.

While this is an oversimplification of reality, a more holistic (and therefore, complex) mathematical model that allows you to incorporate as many factors as you want will be more adept at assessing the risk of a particular innovation.

LIMITATIONS Acknowledge the limitations of your model. While this may sound self-contradictory, you have to understand that no mathematical model can be complete. In addition, you should be able to tell an incorrect model from an incomplete one. An incorrect model is one whose underlying assumptions are fundamentally flawed.

Merton explains: “An aircraft navigation model that places New York’s La Guardia airport in Boston might not be recognised as flawed unless the planes it guides try to fly to that airport. Once a model is found to be based on a fundamentally wrong assumption, the only proper thing to do is to stop using it.”

An incomplete model on the other hand, can be improved as long as you acknowledge its limitations intelligently.

UNFORESEEN Always expect the unexpected – despite the best endeavours and ingenuity, some factors that should go into a model may be overlooked.

No human being can possibly foresee all the repercussions of an innovation, no matter how obvious they may seem in hindsight. This is particularly true when an innovation interacts with other changes in the environment that are unrelated and not recognised as risk factors. The 2007/08 financial crisis is a classic example of unintended consequences of innovations in finance.

USE AND USER The utility of a model depends not only on the model itself but on who is using it and what it’s being used for. A more complete but more complicated model may carry greater risks than a cruder one unless the user is qualified for the job.

In this regard, the US credit rating crisis is an important case in point. So many investment managers misapplied a model that resulted in huge losses and ‘AAA’ rated bonds piling up in their portfolios.

INFRASTRUCTURE Before an innovation is introduced, see if it’s compatible with the existing infrastructure or whether further improvements are needed. For instance, if you want to introduce a high-speed passenger train to your railway network, your existing tracks must be able to support it. Otherwise, you risk a train crash at some point, leading to a massive loss of lives and critical damage to the railway infrastructure.