Here are some others that you should consider. (Note that there are excellent materials out there for you to read, watch and listen to, so treat this as a checklist of useful terms rather than rigorous or comprehensive definitions!)
- Incentives, and expected values: We have mentioned incentives several times in this blog. Incentives are the outcomes that motivate behaviour. They can be positive or negative, and they can be used to induce desirable behaviours or inhibit undesirable ones. They can also be of a fixed, known value or they can have an expected value. Let's cover this in a little more detail: An outcome doesn't have to be fixed and known, in order to function as an incentive. It can be a likely outcome over a range of values.
- Should you bet $50 on a coin toss, if heads means you get $100 and tails means you get $0? The expected outcome of the game is $50 (50% chance of getting $100 plus 50% chance of getting nothing), so in theory, you should be indifferent between playing and not playing. As we will see in a second, many people would prefer to hold on to the $50 in their pocket, rather than play a game with expected value of just $50.
- Loss aversion and risk aversion: The experience of loss and the experience of gain are asymmetric. Generally, a person will experience the pain of losing $100 more acutely than they will experience the pleasure of winning $100. Loss aversion helps explain many behavioural tendencies, including risk aversion. Risk aversion is the tendency to prefer an outcome that is fixed and certain over one that are probabilistic even if they have an equivalent expected value. In the game described above, though the expected value of the game is $50, the fact that it is a game with an uncertain outcome makes it less attractive than the certainty of the $50 that is in your pocket.
- Risk-neutral and risk-loving actors: For completeness, we should acknowledge that yes, despite the overwhelming tendency for humans to be risk averse, it isn't always the case. Some people successfully insulate themselves from their risk averse tendencies, perhaps by training themselves, or by entrusting their decisions to an risk-neutral model. And there are situations where we see people getting more value out of risky outcomes than safe ones. If you want to watch a risk-neutral algorithm interact with a risk-loving human, you can hang out by the slot machines at your local pub or casino.
Modeling risk aversion at the individual level
Let's tie these concepts together in a simple model.
In this model, there are two agents, "Red" and "Blue". Both are human beings who respond rationally to incentives most of the time. That is to say, when presented with the opportunity to do something, they will weigh up:
- the size of the resulting benefit and
- how likely that benefit is to materialize.
Like most humans, most of the time, they are both risk averse. What does this mean? It means that the reward will be less valuable if it involves a risk of loss. And the more risk involved, the less valuable the reward becomes.
But now imagine that Red is more risk averse than Blue. Let's not worry about why that's the case for now - it could be a combination of personality, incentives and culture. (In fact, in another post we will talk how to select for, and design around different levels of risk aversion.) What does this mean for their relative behaviour? It means that it is harder to incentivize Red to engage in a risky course of action. In other words, the payoff would have to be a lot higher for Red to take on the same amount of risk. Blue, on the other hand, may need to be restrained from taking on more risk than the organisation can handle.
I'll illustrate with the help of some gentle caricatures.
A day in the life of a Red and a Blue
"Red" is a tax accountant in the finance department of a company. They spend most of their day receiving copies of sales invoices and purchase orders from different parts of the company, and ensuring that the correct tax entries are made in the relevant accounting journals. Their success is based on having a firm grip on the rules that govern tax accounting, having the organizational ability to handle dozens of incoming items a day, having the discipline to follow a well-defined process, and maintaining good records while doing so.
"Blue" is a B2B salesperson. "Blue" spends most of their day sifting through lists of potential buyers, using the internet to work out the contact information for someone in the purchasing department, and "cold calling" them to try and make a sale. Their success depends largely on the quality of the product, the state of the economy, whether the purchasing department contact information is up to date, and whether the person they get through to is in a good mood that day. But it also depends on their understanding of the market, and their ability to sense changes and adapt their approach to take advantage of opportunities. And in a crowded field, it helps to stand out. Boldness, creativity, and a sense of adventure can be helpful character traits.
Connecting job performance to business performance
How does their individual performance affect the company's profit and loss?
In the case of "Blue", any deal they close will boost the "top line" of the income statement (i.e. it will add revenue). The bigger the deal, the bigger the boost. And there is no limit to the upside. What happens if they fail to make a sale? Not much. The company is just stuck with the salary they have committed to pay "Blue", and whatever it cost the company to provide a desk, a phone and an internet connection.
What about "Red"? If "Red" manages to get every single tax amount booked correctly by the close of business, and maintains an unimpeachable set of auditable records, what will be the effect on the company's revenue? Absolutely nothing. But what happens if they fail to do their job well? The outcomes range from the mundane and irritating (penalties for late submission of records, delayed collection of tax refunds from the authorities) to the catastrophic (fines, fraud and failed audits). In fact, there is almost no limit to the downside.
This asymmetry informs everything about that person's relationship to their work.
When it comes to hiring:
- Reds are selected for their ability to diligently observe rules, to detect and investigate anomalies, and a resistance to boredom.
- The Blues of the world are hired for their creativity, energy, and ability to sense signals from the market and adapt their approach accordingly.
When it comes to incentives (positive and negative):
- The Blues are richly rewarded with commission - they get to keep a portion of the upside that they generate for the firm, which is potentially unlimited. They are not often punished for failing to make a particular sale - companies recognize that many factors are beyond the control of an individual salesperson - and a salesperson who has a low "strike rate" will probably quit in frustration before the company gets around to actually firing them.
- By contrast, Reds are rewarded with steady base salaries and long-service bonuses, reflecting their value as knowledgeable, reliable custodians of important processes. Also by contrast, Reds are severely punished for violating process, for dishonesty, and for inattention, because all these behaviours expose the company to large downsides.
To summarize: a Blue taking risks creates large potential upside and limited downside. A Red taking risk generates negligible upside and large potential downside.
Here's a stylized picture of how that looks:
We'll return to this in later posts.
So what?
So what does this mean for you? A whole lot. Whoever you are dealing with, whether they realize it or not, is a Red or a Blue (or maybe a Purple). And you will find them a lot more predictable, and a lot more co-operative, if you account for this when dealing with them. You need a client's Head of Sales to provide a list of products that will be sold under a new contract? They'll likely respond quickly. You should probably check that they haven't included items that they want or hope to sell, but that haven't been signed off by the CEO. (Sales teams are prone to taking risks that maximize their upside.) You need a client's General Counsel to sign off on the comprehensive list of trademarks associated with that product? Don't be surprised if they try to do the most thorough job they can, even if it delays the transaction. And definitely don't be surprised if they react very badly to attempts to get them to hurry up. (They are just minimizing risk to the company.)
A note of caution
People are wonderfully complex. Understanding whether someone you are dealing with is a Red or a Blue is a handy starting point. But that's all it is. A person's "Red-ness" or "Blue-ness" is only one aspect of who they are, and even that aspect might be very context-dependent. In my view, one of the best ways to improve one's understanding of people, is to read fiction. Lots of it. And the more literary, the better.