Risk Management | Time Preference and the Battle for Efficiency

Redundancy, often considered the antonym of efficiency, is perceived as a dirty word, and seen as referring to an impediment to short-term profits. However, recent history showed us how fragile the systems we created in our craving for efficiency and short-term thinking have become. Cutting beds in intensive-care units in good times because “we don’t need them” invisibly makes you vulnerable in a health crisis. Shutting down a nuclear power plant because “we can meet power demand with cheap gas” makes you susceptible to a supply shock.

While chasing efficiency might improve your P&L, you are adding silent risk and fragility. Complex systems (like organisations) need redundancy to survive and absorb shocks; hence, businesses should embrace and imbed redundancy to mitigate risk and increase performance in the long run.

This series of articles tries to provide a different perspective on risk management by using analogies from real life that help companies understand the role and importance of enterprise risk management. Also, they discuss how to deal with uncertainty and randomness and make adjustments to well-known risk management frameworks, how understanding and applying incentives is key to effective risk management, how to use first principles when solving complex problems, and how to lower the time preference of your decision-makers.

Time Preference

The mindset that embeds risk management in your organisation.

The preceding articles in this series sought to change perspectives on neglected aspects of risk management, such as dealing with complexity and uncertainty, the role of redundancy, ^[1] black swan events, becoming antifragile using optionality ^[2] and considering skin in the game. ^[3]

It can be challenging to apply all these concepts in your organisation in a structured and consistent manner. Therefore, we wish to introduce one overarching concept that can help you and your organisation, your employees and your stakeholders to start embedding risk management in decision-making: time preference.

This term refers to the relative value given to consumption of goods over time. As time is the scarcest asset we have, something obtained in the present is consistently considered of higher value compared to when the same thing is obtained in the future. This is why in finance, future income is typically discounted when valuing a company or stock. Hence, time preference can be defined as the extent to which you value receiving a benefit in the present (high) versus the future (low).

This concept is supported by a common theory in psychology described as delayed gratification. The essence of this theory is that humans tend to chase immediate gratification over a reward in the future, even if the reward in the future is greater. The initial and most prominent study showing this was the Stanford marshmallow experiment. In this study, a group of children were individually offered a choice between one small but immediate reward or two small delayed rewards. Subsequent studies that followed the children showed that the ability to delay gratification is an indicator of success, represented by higher test scores, superior fitness and other life measures. ^[4]

Risk management essentially is the process of reducing the time preference from instant gratification to future payouts. Think about Formula 1 drivers who do so by slowing down (adding redundancy) to reap the benefits by making it to the end of the race, instead of setting the fastest next lap now and risking a crash or wearing out their tires.

Alternatively, assessing the skin in the game of decision-makers can help in identifying high time-preference risks. Politicians, doctors and other decision-makers who have been delegated with the task of making a decision for you have the short-term incentive to solve the immediate issues but may neglect long-term (and potentially unintended) consequences, thereby increasing their time preference. So, would the decision-makers in your company pass the marshmallow test? Are they able to delay gratification, thus lowering their time preference?

Differences in time preference are exemplified in various types of company ownership. Family-owned businesses tend to have a low time preference, because they make decisions to benefit the next generation, while management at public companies makes decisions that optimise the next quarterly earnings, boost their key performance indicators and maximise their bonuses, or respond to the fear that shareholders will sell their stock on the news of unsatisfactory results.

As an owner of a company — or of your personal health or of any other domain — you therefore must be mindful that the risk of higher time preference increases when you delegate or outsource decision-making. A practical analogue to this is being a homeowner: Imagine that the roof on your house requires maintenance and you outsource the work to a contractor. Will they apply shortcuts and use cheap materials only to be applauded for reducing the repair spend? That will expose the roof to future leakage and elevated future maintenance costs. The contractor will have moved on and cannot be held liable, while you still live under that roof (analogous to being a shareholder of a company, or a citizen in a community, subject to similar consequences).

In recent times, numerous industries and individual companies have experienced a wake-up call prompted by black swan events that have severely disrupted their supply chains. These supply chains were originally built around the efficiency principle of just-in-time inventory management, with insufficient redundancies build in to cushion against unforeseen disruptions. This emphasises, again, how high time preference may yield short-term profitability on your P&L but conceals risks that can ultimately jeopardise the long-term viability of your organisation.

Lowering the time preference of your decision-makers, governed by antifragile, or resilient, strategies, designs the right skin into your game, avoids the risk of ruin and simply helps you win over the long run. You want to have decision-makers make decisions today that benefit the future. Without this strategy, you are exposing your interest to unbeneficial outcomes disguised as short-term achievements.

Risk managers should have the ability and organisational position to assess, identify, describe and act on high-time-preference decision patterns and situations within an organisation. Risk managers should propose changes to organisational structures, strategies and incentive schemes if the company is exposed to such high-time-preference decision-makers. It’s a neglected and silent but immediate risk to any company if your company is unknowingly steered toward unfavorable results by favoring the present over the future.

[1] https://www.protiviti.com/nl-en/whitepaper/risk-management-role-and-purpose-enterprise-risk-management

[2] https://www.protiviti.com/nl-en/whitepaper/risk-management-dealing-uncertainty-and-complexity

[3] https://www.protiviti.com/nl-en/whitepaper/skin-game-its-all-about-incentives

[4] Walter Mischel, The Marshmallow Test: Why Self-Control Is the Engine of Success (New York: Little, Brown, 2015).