Risk taking's positive side

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When we talk about farming risk most of us immediately think about the negative consequences stemming from a management decision gone wrong. But taking risks is also the path to rewards

To manage farming risk effectively we need to understand both the negative and positive consequences of taking risks.

Traditionally, we have calculated the anticipated profit from a particular farming decision by multiplying the expected average yield by the average price less the average costs. While this type of analysis is fine if we get the average values, in reality we rarely do! 

Photo of man kneeling in field with sheep in distance

Cam Nicholson, Grain & Graze 2 southern region coordinator, with sheep grazing on wheat stubble at his Bellarine Peninsula property in Victoria.

PHOTO: Lydia Nicholson

To make this traditional analysis more meaningful we can include a ‘scenario analysis’ by testing our anticipated profit with some yield/price/cost values on either side of the average.

But the problem with most scenario analyses is that we still have no idea how often a particular value (average or otherwise) might occur; for example, will yield be higher than average two years in 10 or five years in 10?

In reality, the key profit drivers in agriculture – yield, prices and input costs – present as a range of values over time in response to seasonal and market conditions. By using the traditional ‘average’ method to calculate the anticipated impact of a decision we usually overestimate the profit and hide the volatility in those profits. 

Managing risk is not about the middle or the expected. It is the opposite. It is what happens at the extremes that is important to farm profit. It is about managing for the inevitable poor seasons and, perhaps even more importantly, what we will do when we get a good result. 

In Grain & Graze 2 we set out to get a better handle on farm business risk by using the @RISK software program to analyse how farm profits responded to a range and probability of likely prices, yields and costs.

We wanted to show:

  • how extremes in yields, prices and costs influenced the range of farm profit over time (how high it could be and how low);
  • how often these extremes occurred over time; and
  • which of these variables contributed most to profit volatility and extremes.

With this information we were able to show workshop participants what their individual farm risk profile looked like and start the conversation about how management decisions changed this profile. 

The @RISK analysis is more realistic than an ‘averages’ approach because it combines a value (how big or small)
with a likelihood (how often). This approach builds context and helps us understand exposure and risk (see Beware average prices). 

Risk

Risk = likelihood (frequency) x consequence (impact)

How often are decisions made without recognising and separating the likelihood and the consequence? Decisions that increase the likelihood of an event happening can have either a positive (higher returns) or negative (profit loss) impact.

The tension between risk and reward

There is no reward without risk. Risk is a necessary part of achieving a farm business return. You can make decisions to reduce risk but these usually come at a price, namely lower returns. Managing risk is about making decisions that trade some risk for some return. The challenge is that we usually want both – high returns and low risk. This is not easy to achieve.

Risk, uncertainty and probability

‘Risk’ and ‘uncertainty’ are often used interchangeably but I believe there is a useful distinction. Risk indicates there are knowable odds that something will happen. Uncertainty indicates there are unknowable odds that something will happen (‘we couldn’t have predicted this one was coming’). Because risk is associated with knowable odds or probabilities, we can calculate the likelihood of certain events occurring. This is the approach that was used in the Grain & Graze 2 @RISK analyses.

Personal position on risk

Everyone has a different position on risk that constantly changes with circumstances. It is important to remember that no risk position is right or wrong. It is what you are willing to live with. While it is possible to understand why a person has a particular position on risk and therefore makes particular choices, ultimately we have to accept their risk position and work within this to achieve positive outcomes.

‘Good’ versus ‘right’ decisions

A good decision is what is right for the grower and their business, family and stage in life. Good decisions are informed decisions – for which the consequences are fully appreciated. Whether a ‘good’ decision is also a ‘right’ decision is a matter for hindsight. To improve the chance of a good decision also being the right decision we need to ensure that we increase our chances of a favourable outcome, which requires good analysis and discussion prior to the decision being made.

A fact sheet on Strategic Risk Management is available at: http://grdc.com.au/GRDC-FS-StrategicRisk

More information:

Cam Nicholson, Nicon Rural Services,
nicon@pipeline.com.au
,
0417 311 098

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Region National, South