What it means
The distinction comes from the insurance industry. Pure risks, like a warehouse fire or a car accident, can only hurt, so they can usually be insured against.
Insurers price them using large amounts of past data on how often they happen. Speculative risks can help or hurt, and they are taken on deliberately in the hope of a reward.
Because gains are possible, insurers generally do not cover them, since the chance of loss is part of the bargain. Businesses are full of speculative risk.
Investing in new equipment, entering a foreign market, setting a price or buying a competitor all have uncertain outcomes, and success depends on judgement as much as luck. Two firms making the same decision can end up with very different results.
Good decisions weigh the possible gain against the possible loss and their probabilities. Managers use tools such as expected value, scenario analysis and limits on how much to commit.
Writing down the assumptions behind each estimate makes it easier to learn from the outcome. Controlling speculative risk is different from avoiding it.
Companies reduce the downside by testing ideas on a small scale, phasing investment, using contracts to fix prices and keeping reserves, while keeping the chance of upside. A staged approach also creates decision points where the project can be stopped.
It also helps to separate the risks you can control from those you cannot. A new product's design is under your control, but customer taste and competitor reactions are not, and planning should reflect the difference.
In practice
Real-world examples.
Example
A retail chain opens a store in a new city. If locals love the brand, profit could reach $400,000 a year, but if footfall disappoints the store could lose $150,000 and be closed. The management team would then bear the cost of exiting the lease.
Example
An investor buys shares in a young technology company. The price may double or fall by half, and nothing about the purchase is insurable. The investor can only limit exposure by deciding how much to commit.
Example
A farmer plants a crop that has high prices this year. If prices stay high she makes a strong profit, but if prices drop the crop may sell below cost, while a hailstorm that destroys the crop is a pure risk she can insure. The two risks sit side by side in the same decision.
Formula
Calculation
Expected value = (probability of gain x gain) - (probability of loss x loss)
A company is considering a new product line. There is a 30% chance it earns a profit of $200,000 and a 70% chance it loses $50,000. Expected value = (0.30 x 200,000) - (0.70 x 50,000) = 60,000 - 35,000 = $25,000. The expected value is positive, but the company should still check whether it could survive the $50,000 loss, since the actual result will be either a gain or a loss, never the average.Case study
Seen in the real world.
Brightway Cafes is an illustrative, fictional chain that wanted to expand into airports. A new outlet needed an investment of $300,000 and might earn $120,000 a year if passenger numbers were strong, or lose $40,000 a year if they were weak.
The finance director estimated a 60% chance of strong traffic and a 40% chance of weak traffic. Expected annual result = (0.60 x 120,000) - (0.40 x 40,000) = 72,000 - 16,000 = $56,000.
The illustrative company decided to go ahead but with a pilot in one terminal first and a lease clause allowing exit after two years. This kept the possible gain while capping the loss, which is the standard way of managing speculative risk. The board asked for a review of the pilot results before approving any further outlets.
Watch out
Common mistakes.
- Assuming a positive expected value means the decision is safe, when the actual outcome could still be a large loss that the business cannot absorb.
- Trying to insure speculative risks, which insurers normally do not cover, because the chance of loss is part of the deal.
- Ignoring the size of the possible loss and focusing only on the possible gain, which leads to over-optimistic decisions.
Questions
People also ask.
What is the difference between pure risk and speculative risk?
Pure risk can only produce a loss or no loss, while speculative risk can produce a gain, a loss or no change. Insurance exists for the first kind and strategy for the second.
Can speculative risk be managed?
Yes, through testing on a small scale, phasing spending, diversification and contracts that limit exposure, although it cannot be eliminated. Regular reviews let managers adjust before small losses grow.
Why do businesses accept it?
Because without taking uncertain risks, there is no chance of growth or profit, and the reward for success is the reason for the risk. The task is to take the right risks in the right size.
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