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Understanding risk is key to farm success

Understanding risk is key to farm success
Recognize the probability of experiencing a loss on your farm and fairly balance that against potential gain

We have all heard of the concept of risk versus reward. The more risk you are prepared to tolerate, the greater the potential reward.

Often times, to achieve success we need to take risks to reach success. But human nature can work against one's own best interest.

What, exactly, is risk?
• A situation involving exposure to danger;
• the possibility that something unpleasant or unwelcome will happen; or
• the possibility of financial loss.

For most of us we would say that risk is the chance that something bad might happen. For example, your business could fail or your financial investments could go down in value.

Recognize the probability of experiencing a loss on your farm and fairly balance that against potential gain

But human nature is funny. We value risk differently when we look at gains versus losses. Researchers have given this particular human tendency the name Loss Aversion.

Loss Aversion
Loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains. Most studies suggest that losses are twice as powerful, psychologically, as gains.

Loss aversion was first demonstrated by Amos Tversky and Daniel Kahneman in a scientific article appearing in American Psychologist in 1984. Loss Aversion states that "humans hate to lose twice as much as they like to win."

For example, suppose you have the chance to choose between two investments:
Option A has a track record of growing 5% each year over the last three years, and
Option B has a track record of growing 12% the first year, losing 2.5% the second year and growing 6% the third year.

Researchers will tell you that more people will choose Option A over Option B even though these two investments achieve the same total return after three years. People will take the steady 5% and avoid the possibility of an occasional 2.5% loss.

The challenge is to understand the true probability of experiencing a loss and fairly balance that against the potential gain. It calls on people to be brave enough to choose the path that leads to the success they desire.

Do you find that you are resisting expanding your operation to make room for the next generation?

Do you worry about the down side of bringing in an outsider to provide management expertise to help grow the business?

Are you worried about paying off loans to build an expanded grain storage facility?

Making these prudent decisions is not easy and it does not come naturally to most of us. This is another case where a trusted expert who is working in your best interest can be of huge value. The professional experience and discipline of a proven process can help you have the courage to do the right thing and embrace an appropriate amount of risk to get the results you seek.

Read more on Loss Aversion and the research of Daniel Kahneman.

If this blog has got you thinking about your own situation, get in touch with my office ([email protected]).


The opinions of Rich Dunn are not necessarily those of Farm Futures or the Penton Farm Progress Group.

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