Don’t be a gambler, be a casino

Don’t be a gambler, be a casino

Few things make eyes glaze over like the words “risk management.” Quantifying and managing risk sounds boring… but a surprising number of people do it for fun. Risk management is the core of the casino industry. As someone whose life is about quantifying and managing risk in growth portfolios (boring), maybe I can jazz it up a bit by illustrating how it works in casinos (fun)?  The point is, it’s fun to quantify and manage risk when it helps you triumph over those with lesser tools.

At a slot machine, the hope is to get lucky (make a profit) before running out of money. The gambler usually doesn’t know the machine’s odds, and even if they’re known, the gambler has limited ways to manage those odds (there are only so many buttons or levers).

slot-machineThe casino, at the other end, knows everything and has disproportionate control. It sets the payback percentages for each machine. It also has varied risk management options (it can add or remove machines from the casino floor, it can change the payback percentages or differ them across machines, it can change the minimum and maximum bet sizes, it can offer free alcohol, buffets and hotel rooms).

The equation is lopsided and gamblers know it. So they use pseudo-science to trick themselves into gambling anyway. Do machines seem “hot”? Should you stalk people who feed a machine, then rush in when they leave? Do machines pay better at certain times of day? Does the location of the machine matter? Does the longer you play impact the likelihood a machine will pay? If the people in the security control room like the look of you, will they push a button and let you win more? Rabbit’s foot? Lucky hat?

Under the hood, here’s how brutal slot machines can be:

The “payback percentage” is the percentage of money put into a slot machine that is paid out to gamblers. With a payback percentage of 95%, the casino takes 5% of all money put into the machine and gives away the other 95%. Most payback percentages are between 90 – 97%.

Sounds pretty good huh? The casino only takes 5% and pays a huge majority (95%) back to players. How generous! However, you may have noticed the casino gets its 5% each time. If you start with $100, you’re only likely to get back $95 (in this simplified example). Play again, and you’re down to $90.25, then $85.73, $81.45, $77.37, etc.

What about jackpots?

Casinos have those covered too. Imagine a machine with five possible symbols (bar, cherry, dice, etc.). In this case you’re likely to get five identical symbols once every 625 spins. Assuming you bet $1 per spin, you’re almost guaranteed to win the jackpot after paying $624. Problem is, if the machine has a 95% payback percentage, the size of your hard-won jackpot will only be $592.8. You’d win the jackpot but still lose money. Jackpots are calculated to make the casino money, not you.

That’s why it’s more fun to be a casino than a gambler. With the odds stacked against them, it’s astonishing people gamble at all.

The same could be said for corporate innovators. New products, acquisitions and venture capital investments typically lose money 70% – 90% of the time. Despite the many things humans have learned about innovation, strategy, pivoting, product launches and M&A, the success rate hasn’t moved since the days of Thomas Edison. Companies are the “gamblers,” making expensive, time-sucking bets on innovations in the face of known, terrible odds.

As a result, a lot of pseudo-science has emerged to help innovators sleep at night (or to sell books). Steve Jobs fans say it’s about never compromising, but Jim Collins Good to Great fans propose the opposite – being super humble all the time. Coca-Cola, Gillette and Sony fans tout first-mover advantages, while Zara, Samsung and Amazon fans trumpet fast-follower or late-mover advantages. Tom Peters wrote In Search of Excellence, Fred Crawford wrote The Myth of Excellence. John Hagel wrote Out of the Box, Kirk Cheyfitz wrote Thinking Inside the Box. This isn’t to criticize anyone. Rather, it’s to make an obvious point: there are credible theories, catchphrases or anecdotes to support just about any course of action, and its opposite. We simply must do better if we’re ever to stop gambling.

If corporate innovators are the gamblers, who’s the casino?

The market itself is the “casino.” Nobody owns it. Nobody controls it. Yet like a casino, it keeps the odds hidden from most people and is the relentless arbiter of corporate life and death. I’m not talking about the “stock market”, but the savage wilderness where companies battle every day for customers and profits. When one company falls (ex. Blockbuster), others rise (ex. Netflix)…

…which brings us back to where we started. For businesses to improve their innovation efforts beyond 70% -90% failure rates, they need to start quantifying and managing risk. For real. It’s about cold, hard numbers and the long, thankless, hard work it takes to know if those numbers are reliable. Like a casino, innovators need to know the odds of each growth bet and have a range of tools to tilt the probabilities in their favor. This won’t be accomplished using pseudo-science, platitudes, anecdotes or rabbit feet. Sustained improvement has to come from statistical tools – just ask any actuary at an insurance company, high performing risk manager on Wall Street, Warren Buffett, or a well-run casino.

Until corporate innovators can shift from being gamblers, to becoming casinos, they can expect to lose money in the long-run. Meanwhile those who tackle the issue may surprise themselves by how fun it can be to quantify and manage risk when it helps triumph over those with lesser tools.

 

This Post Has 2 Comments

  1. I don’t know why risk mgt is so alien to company innovation projects since it is so well used in every other part of risk mgt. Curious about how you do it. Thanks for making me think something new.

  2. Interesting perspective. I wonder how innovation-based businesses (meant broadly as the whole ecosystem: startups, VCs, service providers, and investors) can take control of the market without stifling innovation. The problem with structured markets is that they tend to produce predictable behaviors, outcomes and in doing so they eliminate the emergence of the more disrupting business models and products. But the pendulum must swing and it’s probably true that this is already happening. One could argue that crowdfunding businesses are already tapping this opportunity. I believe that human socio-psychology will keep that pendulum swinging between a rational structured state with predictable outcomes and a more chancy creative and sometimes absurd state where new creations and new leaders can emerge through gambling. I would say that timing the pendulum is an effective way of taking advantage of this immutable phenomenon.

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