The Role of Risk in Explaining Differences in Profitability

This study examined the role of risk in explaining cross-sectional differences in the profitability of business units. Applying suggestions of financial theory, we disaggregated risk into two components-systematic and unsystematic-that are thought to have different effects on return. Drawing on the PIMS data base, we found each component of risk to have a substantial, significant, and different impact on return on investment (ROI). The research and strategy implications of the roles of risk are discussed. The two key factors in any investment decision are return and risk. Under the assumption that investors are risk-averse and seek to minimize the risk for any level of expected return, intuition suggests that additional return must compensate investors for assuming additional risk. Scholars in finance and other disciplines have devoted a great deal of work to refining and formalizing this intuition. This same logic applies in the context of strategy, as Wensley (1981), Bettis and Mahajan (1985), and others have observed. A strategic investment decision should explicitly consider risk-decision makers should demand a higher return for an investment involving high risk. Yet, in typical practice, strategic investment decisions are adjusted for risk ad hoc, if at all. Firms typically set relatively high hurdle rates in making go/no go investment decisions and apply these rates to all investments, regardless of their riskiness (Hayes & Gavin, 1982). Further, historical evaluation of existing strategies, whether it concerns evaluating present management or attempting to place values on businesses to be divested or acquired, focuses almost exclusively on return and rarely attempts to quantify risk. These failures to account for risk adequately will unquestionably lead to inappropriate decisions. All else being equal, if firms judge business performance only in terms of return, regardless of risk, they will place more resources than warranted in risky strategies, forgo profitable opportunities, and apply misguided performance evaluations. Further, if researchers do not control for risk in studies assessing the effects of strategic factors on We would like to thank the Strategic Planning Institute for providing access to the data used in this study.

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