Double or Lose?
Games are often used as analogies to explain strategies and decision making in business.
Chess and warfare have always been closely related. Chess may make a good analogy for war, but it only works as an analogy for business for the truly paranoid. You need to believe that all the world has conspired against you and is plotting for your ultimate checkmate before a chess analogy really make sense in business.
Poker is often used as an analogy for negotiation. It's not always the cards you have been dealt, but what the other side thinks you have that may determine the outcome of a negotiation. Consistent bluffing leads to poor outcomes, both in the game and in the real world.
What game, then, provides a good analogy for risk assessment?
I think I've found the answer in a game whose origins stretch back at least two thousand years: backgammon.
The game of backgammon is in essence quite simple. (I hope backgammon players will forgive me as I over-simplify the rules to keep this short). The goal of backgammon is to remove all one's players from the board before the opponent can do the same. The board is set up so that the two players move in opposite directions. The players take turns in rolling two dice: they then move their pieces in accordance with the number of pips on each die. If two or more of the opponent's pieces occupy a space or “point” on the board, then you cannot land on it. However, if only one of the opponent's pieces is on a space then you may land on it. The opponent's piece is sent off the board, and must be brought back on the board to restart its travel. This leads to two major strategies: blocking the opponent's progress by placing two or more pieces on selected points (the blocking game), or trying to get one's own pieces off as quickly as possible (the running game).
So far as we have described it, backgammon is a combination of luck and skill. The possible moves are controlled by the dice (luck), the exact moves are chosen by the player (skill). This makes for an interesting game even if the players are mismatched. With luck a novice can beat a skilled player, but over time the skilled player will win more games than the novice.
We can make similar observations about business success: businesses may succeed through a combination of luck (things beyond their control) and skill (things within their control). On average the more skilful business will succeed more often than the less skilful business, but occasionally luck will beat skill.
However, the part of backgammon which makes it an interesting game from a risk perspective is the introduction of the doubling cube. This addition to the rules is thought to have originated in New York in the 1920s. Before he or she rolls the dice, your opponent may offer you the opportunity to “double”. If you accept, you are now playing for twice the stake (backgammon is most interesting when played for money); if you decline, you have forfeited the game.
Compare this with the decision business managers are often faced with concerning a major project: suddenly an unexpected problem occurs, and either they must invest much more money (increasing the stake), or give up and forfeit the money that has already been invested.
Many major engineering projects have had to face such difficult decisions. Some, such as the Channel Tunnel, have continued and succeeded. Others have failed at many times the cost originally estimated.
To make the right decision, a player needs to make a realistic estimate of the probability that the game can be won. If the player underestimates the probability, then he will forfeit games which would have been won and lose money over time. If the player overestimates the probability, then he will tend to invest more money in games which he will ultimately lose. The optimal strategy — accepting a double for games which one has at least a 1 in 4 chance of winning — is only available to the player who can make an accurate assessment of the risk of loss.
Of course, it is not only your opponent that can double. Just as you can invest more money in a marketing campaign if you anticpate greater chances of success, if you perceive that the game odds are now in your favor you can increase your possible gain (and loss) by doubling. Some element of bluff is possible: if your opponent is uncertain of the odds he or she may concede. If on average you are right, you will tend to win quicker or win more money by staking more. But if your risk assessment is consistently inaccurate, then you can expect to go home considerably poorer.
I can't think of any other game which so neatly encapsulates the importance of accurate risk assessment in business. A good estimate leads to good decisions. Consistent under-estimates lead to increased losses. Consistent over-estimates lead to excessive insurance premiums, costly counter-measures, and the abandonment of potentially profitable business areas due to perceived risk.
Just as in backgammon, the quality of your decisions will affect your organization's performance. With one decision you may be lucky; with another, unlucky. Only over time will the quality of your risk assessments become apparent.