Entrepreneurs and Risk: Perception Is Everything

By Alan Morantz

Some people have a tolerance for habanero peppers, others for Cannibal Holocaust or hang gliding over active volcanoes. Entrepreneurs have a tolerance for risk that others don’t share. It’s quite amazing to think how many people start new businesses despite knowing that, at best, only half will make it to their five-year anniversary.

Thanks to some 20 years of research, we know a quite a bit about entrepreneurs and risk. It’s been well established that cognitive biases explain much of this relationship, three in particular: over-optimism, overconfidence, and the illusion of control.

Overly optimistic people are more likely to assume things will turn out well and to underrate the likelihood of bad events. Overconfident people have an inflated faith in their ability to make correct predictions. And people with the illusion of control believe they can master largely uncontrollable events.

Since they are super-powered by these cognitive biases, entrepreneurs tend to underestimate the amount of risk associated with starting a new business and overestimate the value of the opportunities they discover. This isn’t a recipe for success. In fact, many studies have revealed the negative impact of over-optimism on venture formation, business performance, and decisions relating to finances, product lines, and other key issues.

Risk and Business Performance

It’s important to understand that entrepreneurs don’t necessarily relish taking a risk any more than the next person. It’s that they tend to perceive less risk for a given opportunity.

This distinction between risk taking and risk perception is often glossed over by researchers. In studies that try to connect risk to actual business performance, it’s usually risk taking that is measured. And the evidence here is ambiguous.

What about the impact of risk perception on business performance? To try and answer that question, social scientists focused on 611 entrepreneurs in Tanzania. They peppered the entrepreneurs with survey questions designed to measure their risk behaviour and perception. Questions like: How much risk do you associate with betting a day’s income on the outcome of a sporting event, or investing 10 percent of your annual income on a scheme that promises a very high return on savings?

The researchers found that entrepreneurs who were willing to take a lot of risk but generally perceived few risks showed the poorest performance. They earned up to 40 percent lower revenue than others in the study. Entrepreneurs with a higher perception of risk in general earned higher revenue.

Keep in mind that this study was fairly small and based on entrepreneurs in a developing market. That’s a very different environment than, say, North America. Still, it does remind us that entrepreneurial risk is complex. When tying risk to business outcomes, it’s important to consider not only the willingness to take a risk but the perception of risk as well.

After all, good entrepreneurs excel at managing risk, not taking risk. They put in measures to mitigate the downside. They choose their partners well. They raise money from a variety of investors. They diversify their products. They apply lean concepts to operations management.

Granted, it’s not easy for entrepreneurs to think about managing risk. They’re not wired that way. But the best of them are sufficiently self-aware to understand the need to push back against their biases. After all, as we learned from Shari Hughson from Smith School of Business, you don’t venture into the wilderness without a map and bear spray and expect to get out alive.

Alan Morantz is editor of Smith Business Insight