THE RISK PREFERENCES OF ENTREPRENEURIAL FIRMS:
MEASUREMENT ISSUES AND BEHAVIOUR
Gregory J Brush
University of Auckland
Track: Entrepreneurship, Innovation, and Large and Small Business Marketing
Abstract
An understanding of the risk preferences of entrepreneurial firms is important, as suboptimal risk behaviour in the form of a strong proclivity to take excessive business
risks, or an acute reluctance to assume business risk, can lead to poorer performance.
There is, however, considerable debate in the literature and business press on the risk
preferences of entrepreneurs. While traditional definitions of entrepreneurship
generally highlight entrepreneurs’ propensity to take risks, there is also a stream of
work that indicates they are more moderate risk takers. One reason for the
inconsistencies in the findings of entrepreneurial risk propensity is that despite its
importance, the scales available to measure the risk propensity construct are generally
poor, often involving artificial, trivial and irrelevant settings, and incompletely
specified consequences and confusing switches of roles. This article describes the
development of a unidimensional five-item scale for assessing a firm’s general risk
propensity, and its application to 238 Australian small high-technology
entrepreneurial businesses. The findings indicate these entrepreneurial firms are
predominantly risk averse and take a cautious and measured approach to risk.
Introduction
There is a high level of agreement among researchers that executive decision makers,
along with their individual characteristics and styles, influence their organisation’s
strategic decision-making processes (Calori, Johnson and Sarnin 1994; Hambrick and
Finkelstein 1987; Hitt and Tyler 1991). Significantly, risk attitudes and behaviour are
crucial variables in managerial decision-making (March and Shapira 1987), and it has
been argued that agency relationships (Harris and Raviv 1979), intentions to adopt
technological innovations (Tabak and Barr 1999) and firm performance (Walls and
Dyer 1996) will vary with the risk preference of the firm. Historically, much of the
management literature has characterised entrepreneurs as risk-takers (Kogan and
Wallach 1964; Miller 1983; Palich and Bagby 1995), although conversely
entrepreneurs have also been described as risk avoiders (Webster 1976). Miller (1983)
observes that an important strength of many small firms is an entrepreneurial mindset,
which engenders innovation, proactiveness, and risk taking. However, Brockhaus
(1982), in his review of entrepreneurial risk taking literature, found entrepreneurs
were only moderate risk takers; and overoptimistic perceptions of the risk involved in
new ventures may have led external observers to perceive entrepreneurs have a high
propensity to take risks (Cooper, Woo and Dunkelberg 1988).
The importance of understanding entrepreneurial firm risk preferences is twofold.
First, understanding entrepreneurial risk behaviour is a contribution to furthering our
understanding of the psychological profile of the entrepreneur and their firm, and the
development of a general theory of entrepreneurship, an important endeavour as
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764
despite a long history of research activity no generally accepted theory of
entrepreneurship has emerged (Bull and Willard 1993). Second, entrepreneurs have
often been found to show evidence of substantial sub-optimal risk management and
framing behaviour (e.g., Cooper, Woo and Dunkelberg 1988; Palich and Bagby
1995), which may negatively affect firm performance. Through better understanding
entrepreneurs risk behaviour, the need for programs which attempt to educate
entrepreneurs and modify the emotional and cognitive processes associated with their
risk management behaviours (cf. Sulsky and Day 1992) can be determined.
Despite risk propensity being often discussed in the business literature, scales used to
measure the construct are commonly weak. Various indirect measures, often
measuring personal risk dimensions, have been frequently used to establish
managerial or business risk propensity. However, given evidence that individuals may
not exhibit stable risk propensities across risk domains (e.g., personal versus business
risks, Sitken and Pablo 1992; Walls and Dyer 1996), inferring business risk
propensity from personal risk preferences may be ill-advised. Other, more direct,
measures have also been used, although these direct measures are in settings often
artificial, trivial and irrelevant to business managers. Given the importance of risk
propensity in marketing and entrepreneurial research, a valid and reliable business
risk propensity measure is needed. The present study is designed to address this need,
with the objectives being to develop a simple, parsimonious and easily applied
multiple-item scale to measure firm’s general business risk propensity, and the
application of this scale to a sample of entrepreneurial firms to gain an understanding
of their risk behaviour. The various sections of this paper describe the development
and application of this scale. First, the conceptualisation of business risk propensity is
considered. Second, previous measures are overviewed. The scale development
process is then discussed, and an assessment of the psychometric properties of the
scale is presented. The paper concludes with the results of the investigation into
entrepreneurial firm risk propensity, a brief summary of the developed scale and its
uses, and opportunities for further work in this area.
The Conceptualisation of Risk Propensity
Risk propensity describes an individual’s attitude towards risk across situations, and
has been considered to encompass the traditional subjective expected utility view of
risk seeking and risk aversion (risk preference), and affective dimensions of
behaviour (Lewin and Stephens 1994). Researchers generally consider that an
individual’s risk propensity can be classified along a continuum anchored between
being completely risk-averse and risk-seeking (Westbrook 1996). Individuals with
low risk propensities attempt to minimise uncertainty, and avoid high-stake problems.
A risk neutral individual is indifferent to adventure or security, whereas a risk-loving
(or seeking) individual is willing to make investments in risky ventures and has a
preference for situations, with equivalent expected value, that have potentially higher
payoffs with increased risk as opposed to certainty in outcomes (Varian 1987). Lewin
and Stephens (1994) consider individuals with high-risk propensity like to - and
indeed enjoy - taking risks with high stakes; they become restless in stable, certain
situations.
Although there is some debate in the risk literature on whether risk propensity is a
stable dispositional trait or an emergent property of the decision-maker, traditional
conceptualisations of risk propensity have most commonly considered the trait as a
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765
stable dispositional attribute (e.g., Kogan and Wallach 1964; Weber and Milliman
1997), and there is support for the hypothesis that the effect of situational variables on
choice may be the result of changes in risk perception (Weber and Milliman 1997).
Individuals can, however, differ substantially in their orientation towards different
kinds of risk (e.g., physical versus financial risks; personal versus business risks; see
MacCrimmon and Wehrung 1986; Schoemaker 1990); although past research
suggests that individuals exhibit stable risk propensities within relatively broad risk
domains (see Sitkin and Pablo 1992 for a review).
Previous Measurement of Risk Propensity
To measure risk propensity researchers have tended to use a lottery technique in
which subjects are asked to choose between risky alternatives and their certainty
equivalents (e.g., Kogan and Wallach 1964; Oliver and Weitz 1991), but such
measures can have validity and reliability problems. For example, although it has
been used in a later study by Brockhaus (1980) to test the risk taking propensity of
entrepreneurs, the situations included in the Kogan and Wallach (1964) measure have
incompletely specified consequences and involved confusing switches of roles.
Other risk propensity scales are often trivial and student-specific, and have used
situations that seem unrelated to actual managerial risk-taking. For example, Sitkin
and Weingart (1995) developed an original five-item measure for business risk
propensity that involved providing a case scenario, based on NASA’s decision to
launch the space shuttle Challenger, in the guise of a decision about whether a race
car team should compete in the last race of the season. Cummings, Harnett and
Stevens (1971) derive a risk measure from managers’ responses to questions about
whether they would like to race cars or jump off high diving boards, and Farley
(1987) used 20 yes-no questions such as “I am high in energy” and “Thinking of
investing in stocks does not excite me” to develop a risk measure. Risk measures
based on risky choices made in a theoretically sound expected utility framework have
also been used in several studies of managers’ risk taking behaviour (e.g., Laughhunn,
Payne and Crum 1980; Wehrung 1989). However, this approach utilises hypothetical
choices, so the understanding and motivation underlying the responses is sometimes
questionable (MacCrimmon and Wehrung 1990).
Given evidence that indicates risk preference has at times shown little within-subject
consistency across domains and situations (MacCrimmon and Wehrung 1986;
Schoemaker 1990), context specific risk preference measurement scales may be
preferred to those overviewed above. For example, Gomez-Mejia and Balkin (1989),
in their study of employee compensation, used a willingness to take risks scale based
on original research by Slovic (1972) and later adaptations by Gupta and
Govindarajan (1984). The scale, which had a coefficient alpha of 0.91, included four
items which measured: (1) the willingness to accept job risk; (2) preference for a low
risk/high security job as opposed to a high risk/high rewards job; (3) preference for a
job with known problems rather than a new job with problems that are unknown, even
if this job offers greater rewards; and (4) the propensity to avoid risk on a job at all
costs. Palich and Bagby (1995) have subsequently used this scale to compare risk
propensity for entrepreneurs and non-entrepreneurs. Jambulingam and Nevin (1999),
in their study of franchise channel relations, measured business risk taking as a
composite construct reflecting whether the business strategy is characterised by a
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766
strong tendency to undertake high-risk projects, the extent to which the manager is a
gambler and believes it is impossible to plan for the future, the importance of
undertaking research before making a risky decision, and the propensity to only take
risks in areas the business knows well. This scale, however, performed poorly with
low item-to-total correlations and a coefficient alpha of only 0.58.
In summary, the majority of risk propensity scales are weak, and although Slovic
(1972), Gupta and Govindarajan (1984), and Jambulingam and Nevin (1999) have
made commendable attempts to clarify the construct, their scales also suffer from
flaws. Jambulingam and Nevin (1999) include an item that measures managers’
tendency to gamble, which may tap into personal risk-taking behaviour, and arguably
fails to reflect the complex nature of risk preference in a business context.
Significantly, MacCrimmon and Wehrung (1985) showed their subjects as more
willing to take risks with their firm's resources than their own. The Slovic (1972) and
Gupta and Govindarajan (1984) scale measures the propensity to avoid risk at all
costs; however, risk propensity involves a risk-return trade-off not an absolute
determination. This study attempts to address the problems and limitations of
previous risk propensity scales. Discussion of the scale development process follows.
The Scale Development Process
In order to develop a valid and reliable business risk propensity measure, a three-stage
process was followed: (1) an extensive survey of the literature was undertaken to
identify the domain of the construct and locate appropriate scales that had been
validated in previous studies; (2) an initial pool of items was generated from the
exploratory search and provided to seventeen small business managers who discussed
their actual business risk behaviour and assessed the face and content validity of the
items, and (3) a determination was made of the items considered to adequately
represent the general business risk propensity domain. These items were provided to a
sample of 1100 small business managers operating in high technology industries to
assess the psychometric properties of the scale, and decide the final composition of
the measurement scale.
Development of the initial pool of items closely reflected the domain of the measure
that considers the risk-reward trade-off decision as being a primary determinant of
risk-propensity (e.g., Slovic 1972; Varian 1987); and includes items reflecting
behaviours that have been found to be important characteristics of risk averters and
risk takers (MacCrimmon and Wehrung 1986). This conceptualization of risk
propensity accords with the psychological literature that suggests that attitudes, values
and personality variables should be operationalised within a limited domain in order
to be related to specific behaviour (Ajzen and Fishbein 1980), and reflects findings
that even with the same assessment method, individuals have not shown themselves
as consistently risk seeking or risk avoiding across different domains and situations,
both in laboratory studies and in managerial contexts (MacCrimmon and Wehrung
1986; Payne, Laughhunn and Crum 1980; Schoemaker 1990). The initial pool of
items, provided to managers in random order, included the following:
•
•
•
Your firm prefers certainty in its business relationships, even if this could involve a lower
level of business performance (RISK1)
Research is important before making a risky decision (RISK2)
Your business only takes risks in areas it knows well (RISK3)
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•
•
•
•
•
Your firm approaches business transactions with a high degree of caution (RISK4)
Your firm’s business strategy is characterized by a strong tendency to undertake high-risk
projects (R) (RISK5)
Your firm prefers to participate in high-risk high pay-off ventures rather than low-risk low
pay-off ventures (R) (RISK6)
Your firm could be considered risk averse in its business dealings (RISK7)
Your firm will undertake high-risk ventures if expected outcomes are satisfactory given the
risk involved (R) (RISK8)
Managers were asked to provide responses to these questions that reflected their
firm’s general attitude towards business risk, without reference to any specific
business relationship or project. Items were measured on a seven-point Likert-type
scale bounded by strongly disagree and strongly agree. Despite developing items that
reflected real choices that were meaningful and understandable to the business
manager, constructing a consistent and reliable risk propensity measure proved
somewhat difficult. For example, some managers indicated that although their
business was risk averse with respect to business relationship risks, the firm was
willing to take considerable risks in the high-technology projects they undertook. A
number of apparent inconsistencies in risk behaviour also became evident, and some
managers indicated a limited understanding of the general concept of risk adversity.
For example, some managers indicated that while they were willing to take high
business risks, at the same time they considered they were cautious in their business
practices. Others indicated their preference for certainty, but at the same time a
willingness to take risks. One possible explanation for these findings may be that risk
preference is not independent from the perceived ability of the decision maker to
control the risk exposure, an observation previously made of entrepreneurs by
Brockhaus and Horwitz (1986).
On the basis of the feedback from stage two it was decided in stage three to retain a
single item that reflected the entrepreneurial firm’s risk propensity in its business
relationships (RISK1) and project selection behaviour (RISK5), and supplement these
two items with three general risk items that have been found to be important
characteristics of risk averters and risk takers (MacCrimmon and Wehrung 1986).
These three items (RISK2, RISK3, RISK4) reflected the firm’s need for more
information before making a risky decision, the need for a familiar environment and
low uncertainty, and the general nature of the firm’s approach to business transactions
(see the above description of pool items for question wording). Although it may have
been valuable to include a greater number of items in the final scale, the overriding
objective was parsimony and simplicity, the domain of the construct is adequately
covered by the items included, and the measures are grounded in risk behaviour
theory.
The revised five-item risk propensity measure was provided to a sample of 1100 small
manufacturing businesses (with between 10 and 99 employees), operating in eight
high technology industry groups, to assess the psychometric properties of the scale.
Usable questionnaires were received from 238 respondents for a net response rate of
21.6%, which is comparable to similar international surveys. The responses were
derived predominantly from small businesses operating in three product classes,
namely other electrical equipment, photographic and scientific equipment, and
computer hardware and other electronic equipment. Over two-thirds of the
respondents indicated that their business had 10-39 employees, which is consistent
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768
with statistics on the size distribution of Australian small businesses. The responding
small firms were generally well established businesses with over 80 percent having
been in operation for more than 10 years, and less than 2 percent operational less than
2 years. Key informants were predominantly the small firm’s CEO (58.4 percent) and
were required to have an acceptable level of personal knowledge of the general risk
behaviour of their business in order to be considered eligible for the study. The firms
in the study are considered entrepreneurial in light of their high level of innovation
and desire for autonomy, both common themes in many definitions of
entrepreneurship (e.g., Baumol 1993; Low and MacMillan 1988).
Initial exploratory factor analysis indicated the five-item scale was unidimensional.
The items were them subjected to confirmatory factor analysis to further examine
their psychometric properties. The one factor confirmatory (congeneric) model for
risk propensity was a good fit to the data, evidenced by the non-significant chi-square
statistic, and satisfactory goodness of fit indices (e.g., Bollen 1989) (see Table 1). The
goodness of fit statistics of a congeneric measure model are also a type of validity
test, since, for the model to fit well, the items must all represent the same latent trait
(Holmes-Smith and Rowe 1994). Further, the individual item loadings were all
significant (p < .01), and the composite scale exceeds the Bagozzi and Yi (1988)
reliability test of _ c ≥ 0.6 that indicates an appropriate measurement scale; and the
commonly accepted threshold value for acceptable reliability for exploratory work of
0.60 (Hair et al. 1998). Given the problematic nature of the measurement of this
construct in previous research, and the exploratory nature of the measurement
development process, the psychometric properties of the scale were considered
acceptable.
Table 1
One Factor Congeneric Model for the Risk Propensity Scale
Item
Factor Loading Goodness of fit measures:
RISK1
RISK2
RISK3
RISK4
RISK5
0.44
0.44
0.76
0.67
0.31
Reliability of scale:
0.66
Chi-square
Degrees of freedom
Probability
Goodness of fit index
Adjusted goodness of fit
Comparative fit index
Normed fit index
6.82
5
0.23
0.99
0.98
1.00
0.99
Results and Discussion
The study findings indicate that the entrepreneurial firms are risk averse in their
business practices, and strongly call into question the conventional view of
entrepreneurs as risk takers. The average of the five risk items included in the final
scale (after coding the responses so lower scores reflect a lower propensity for risk)
was 2.93 (std. deviation = .80), which through a one-sample t-test was found to be
significantly less than the scale mid-point of four (t = -20.696, p < .01). The sample
means for the five individual items were also found to be significantly different than
the scale mid-point (at a 99 percent level of confidence) indicating: entrepreneurial
small businesses preferred certainty in their business relationships even if this could
involve a lower level of business performance (Mean = 4.42); research is important
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before making a risky decision (Mean = 5.71); the business in most cases only takes
risks in areas it knows well (Mean = 5.47), business transactions were approached
with a high degree of caution (Mean = 5.01); and the business strategy was not
characterised by a strong tendency to undertake high-risk projects (Mean = 3.28).
The results indicate that entrepreneurial firms generally appear to take a well balanced
approach to risk management in terms of undertaking research before making risky
decisions and constraining themselves to areas of business they are familiar with, and
arguably can leverage their strengths and core competencies. These findings
corroborate Timmons’ (1994) assertion that entrepreneurs are prudent managers of
risk. Data was also collected on firm sales and size (number of employees) to examine
the effect of risk propensity on performance, while controlling for firm size. The
regression analysis failed to support a significant effect for risk propensity on sales (p
>.50). However, further research is needed to better understand the performance
implications of the entrepreneur’s risk preference behaviour. In particular, the
implications of the somewhat cautious approach to risk and a preference for increased
certainty in decision-making over higher performance should be examined, as Walls
and Dyer (1996) have found that up to some optimal point, beyond which the firm
undertakes "hazardous" investments, a positive relationship exists between the
corporate risk tolerance ratio and ex post returns. Evidence of the variability of firm
risk preferences in this study also question the assumption of the use of fixed firm and
agent risk preferences in most transaction cost, descriptive financial and hidden-action
agency models.
Finally, given that risk propensity is a critical variable in managerial decision-making;
it is somewhat surprising that previous scales used to measure the concept have
frequently been weak. This paper was also an initial attempt to develop a
parsimonious and easily applied scale that could be applied in research into a wide
range of business and marketing settings. The scale presented in this paper improves
on previous measures as the items reflect real choices that are meaningful and
understandable to the business manager, and the final scale exhibits acceptable
psychometric properties. It is hoped future research will continue to refine this
measure, although this is a difficult undertaking given observations that even with the
same assessment method individuals have not shown themselves as consistently riskseeking or risk-avoiding across different domains or situations.
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