Strategy Under Certain

www.hbrreprints.org

Strategy Under Uncertainty

by Hugh Courtney, Jane Kirkland,

and Patrick Viguerie

Included with this full-text

Harvard Business Review

article:

The Idea in Briefthe core ideaThe Idea in Practiceputting the idea to work

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Article Summary

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A list of related materials, with annotations to guide furtherexploration of the articles ideas and applications

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Further Reading

Reprint 97603


page 1

The Idea in Brief The Idea in Practice

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Are you using traditional analytic toolsmarket research, value chain analysis, as-sessments of rivalsto inform your strat-egy? Those tools work in stable business environments. But today were operating amid unprecedented uncertainty. Apply the old tools, and you risk formulating strat-egies that neither defend your company against threats nor leverage the opportuni-ties uncertainty can provide.

Instead, use analytic tools based on the

level

of uncertainty facing your company: Are you facing only two or three alternative futures? Then use tools such as decision analysis. A wide range of possible scenar-ios? Consider scenario planning. Armed with the right kind of information, select an appropriate strategyand execute it through savvy moves.

For example, using scenario planning, financial-services provider Mondex International determined that the advent of electronic cash transactions could create a range of possible futures. Mondexs strategy? Shape its industrys future by es-tablishing what it hoped would become universal electronic-cash standards. Its moves? Make big-bet investments in prod-uct development, complemented by more conservative pilot experiments to speed customer acceptance.

As companies like FedEx and Microsoft have discovered, using the right tools to read the future enables you to avoid disas-trous strategic investments while exploiting fresh opportunities.

CONFRONTING UNCERTAINTY

1. Apply appropriate analytic tools to iden-tify strategic options.

If you envision...

Only a few future scenarios

Use...

Option valuation models and game theory to establish relative probabilities of each out-come and gauge alternative strategies risks and returns

Example:

A pulp and paper company cannot observe or predict its competitors plans for expand-ing capacitywhich could strongly affect industry prices and profitability. Its decision whether to build a plant will hinge on rivals decisions. A limited number of competitor moves are likely. The company evaluates the inherent risks and returns for each sce-nario, using game theory to identify proba-ble market winners and losers for each.

If you envision...

A wide range of futures

Use...

Technology forecasting and scenario plan-ning to develop 45 possible scenarios

Example:

A consumer-goods company considering entering the Indian market develops multi-ple scenarios characterized by different variables, such as customer-penetration rates and latent-demand level.

2. Select a strategic posture.

Strategic pos-tures clarify your strategic intent. They can take three forms:

Shaping

driving your industry toward a new structure of your devising and creating new opportunities. Hewlett-Packard shifted photo processing from stores to homes by offering high-quality, low-cost photo printers.

Adapting

choosing where and how to compete within the current industry struc-ture. Many telecommunications service re-sellers pursue competitive advantage through pricing and effective execution rather than product innovation.

Reserving the right to play

making incre-mental investments to stay in the game without committing to a new strategy pre-maturely. Some pharmaceutical compa-nies reserve the right to play in gene-ther-apy applications by buying small biotech firms with relevant expertise.

3. Build a portfolio of strategic moves.

Use one or more of these moves depending on your strategic posture.

Big bets

major commitments (capital in-vestments, mergers, or acquisitions) that will generate large payoffs in some scenar-ios and large losses in others.

Options

modest initial investments (pilot trials, limited joint ventures, technology li-censing) that enable you to ramp up or scale back your investment later as the mar-ket evolves.

No-regrets moves

actions that pay off no matter what happens, such as cost-cutting initiatives and competitor intelligence.

Example:

Chemical companies often use

options

to

reserve the right to play

when emerging technologies performance is uncertain. Rather than retrofitting old plants around an unproven new technology, they pur-chase options to license the technology within a specified time frame or retrofit a few facilities with the emerging technol-ogy. These small, up-front commitments position them to ramp up or discontinue development of the technology as its per-formance becomes clearer.


by Hugh Courtney, Jane Kirkland,

and Patrick Viguerie

harvard business review novemberdecember 1997 page 2

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What makes for a good strategy in highly un-certain business environments? Some execu-tives seek to shape the future with high-stakesbets. Eastman Kodak Company, for example,is spending $500 million per year to developan array of digital photography products thatit hopes will fundamentally change the waypeople create, store, and view pictures. Mean-while, Hewlett-Packard Company is investing$50 million per year to pursue a rival visioncentered around home-based photo printers.The business press loves to hype such indus-try-shaping strategies because of their poten-tial to create enormous wealth, but the soberreality is that most companies lack the indus-try position, assets, or appetite for risk neces-sary to make such strategies work.

More risk-averse executives hedge their betsby making a number of smaller investments.In pursuit of growth opportunities in emergingmarkets, for example, many consumer-productcompanies are forging limited operational ordistribution alliances. But its often difficult todetermine if such limited investments truly re-

serve the right to play in these countries or justreserve the right to lose.

Alternatively, some executives favor invest-ments in flexibility that allow their companiesto adapt quickly as markets evolve. But thecosts of establishing such flexibility can behigh. Moreover, taking a wait-and-see strat-egypostponing large investments until thefuture becomes clearcan create a window ofopportunity for competitors.

How should executives facing great uncer-tainty decide whether to bet big, hedge, orwait and see? Chances are, traditional strate-gic-planning processes wont help much. Thestandard practice is to lay out a vision of fu-ture events precise enough to be captured ina discounted-cash-flow analysis. Of course,managers can discuss alternative scenariosand test how sensitive their forecasts are tochanges in key variables, but the goal of suchanalysis is often to find the most likely out-come and create a strategy based on it. Thatapproach serves companies well in relativelystable business environments. But when



there is greater uncertainty about the future,it is at best marginally helpful and at worstdownright dangerous.

One danger is that this traditional approachleads executives to view uncertainty in a bi-nary wayto assume that the world is eithercertain, and therefore open to precise predic-tions about the future, or uncertain, and there-fore completely unpredictable. Planning orcapital-budgeting processes that require pointforecasts force managers to bury underlyinguncertainties in their cash flows. Such systemsclearly push managers to underestimate uncer-tainty in order to make a compelling case fortheir strategy.

Underestimating uncertainty can lead tostrategies that neither defend against thethreats nor take advantage of the opportuni-ties that higher levels of uncertainty may pro-vide. In one of the most colossal underestima-tions in business history, Kenneth H. Olsen,then president of Digital Equipment Corpora-tion, announced in 1977 that there is no rea-son for any individual to have a computer intheir home. The explosion in the personalcomputer market was not inevitable in 1977,but it was certainly within the range of possi-bilities that industry experts were discussing atthe time.

At the other extreme, assuming that theworld is entirely unpredictable can lead man-agers to abandon the analytical rigor of theirtraditional planning processes altogether andbase their strategic decisions primarily on gutinstinct. This just do it approach to strategycan cause executives to place misinformed betson emerging products or markets that result inrecord write-offs. Those who took the plungeand invested in home banking in the early1980s immediately come to mind.

Risk-averse managers who think they are invery uncertain environments dont trust theirgut instincts and suffer from decision paralysis.They avoid making critical strategic decisionsabout the products, markets, and technologiesthey should develop. They focus instead on re-engineering, quality management, or internalcost-reduction programs. Although valuable,those programs are not substitutes for strategy.

Making systematically sound strategic deci-sions under uncertainty requires a different ap-proachone that avoids this dangerous binaryview. It is rare that managers know absolutelynothing of strategic importance, even in the

most uncertain environments. In fact, theyusually can identify a range of potential out-comes or even a discrete set of scenarios. Thissimple insight is extremely powerful becausedetermining which strategy is best, and whatprocess should be used to develop it, dependvitally on the level of uncertainty a companyfaces.

What follows, then, is a framework for de-termining the level of uncertainty surroundingstrategic decisions and for tailoring strategy tothat uncertainty. No approach can make thechallenges of uncertainty go away, but this oneoffers practical guidance that will lead to moreinformed and confident strategic decisions.

Four Levels of Uncertainty

Even the most uncertain business environ-ments contain a lot of strategically relevant in-formation. First, it is often possible to identifyclear trends, such as market demographics,that can help define potential demand for fu-ture products or services. Second, there is usu-ally a host of factors that are currently

unknown

but that are in fact

knowable

that could beknown if the right analysis were done. Perfor-mance attributes for current technologies, elas-ticities of demand for certain stable categoriesof products, and competitors capacity-expan-sion plans are variables that are often un-known, but not entirely unknowable.

The uncertainty that remains after the bestpossible analysis has been done is what we call

residual uncertainty

for example, the out-come of an ongoing regulatory debate or theperformance attributes of a technology still indevelopment. But often, quite a bit can beknown about even those residual uncertain-ties. In practice, we have found that the resid-ual uncertainty facing most strategic-decisionmakers falls into one of four broad levels:

Level 1: A Clear-Enough Future.

At level 1,managers can develop a single forecast of the fu-ture that is precise

enough

for strategy develop-ment. Although it will be inexact to the degreethat all business environments are inherentlyuncertain, the forecast will be sufciently nar-row to point to a single strategic direction. Inother words, at level 1, the residual uncertaintyis irrelevant to making strategic decisions.

Consider a major airline trying to develop astrategic response to the entry of a low-cost,no-frills competitor into one of its hub air-ports. Should it respond with a low-cost service

Hugh Courtney

is a consultant in McKinsey & Companys Washington, D.C., office.

Jane Kirkland

is a princi-pal with McKinsey in Pittsburgh, Penn-sylvania.

Patrick Viguerie

is a principal with McKinsey in Atlanta, Georgia.



of its own? Should it cede the low-cost nichesegments to the new entrant? Or should itcompete aggressively on price and service inan attempt to drive the entrant out of the mar-ket?

To make that strategic decision, the airlinesexecutives need market research on the size ofdifferent customer segments and the likely re-sponse of each segment to different combina-tions of pricing and service. They also need toknow how much it costs the competitor toserve, and how much capacity the competitorhas for, every route in question. Finally, the ex-ecutives need to know the new entrants com-petitive objectives to anticipate how it wouldrespond to any strategic moves their airlinemight make. In todays U.S. airline industry,such information is either known already or ispossible to know. It might not be easy to ob-tainit might require new market research,for examplebut it is inherently knowable.And once that information is known, residualuncertainty would be limited, and the incum-bent airline would be able to build a confidentbusiness case around its strategy.

Level 2: Alternate Futures.

At level 2, thefuture can be described as one of a few alter-nate outcomes, or

discrete scenarios

. Analysiscannot identify which outcome will occur, al-though it may help establish probabilities.Most important, some, if not all, elements ofthe strategy would change if the outcomewere predictable.

Many businesses facing major regulatory orlegislative change confront level 2 uncertainty.Consider U.S. long-distance telephone provid-ers in late 1995, as they began developing strat-egies for entering local telephone markets. Bylate 1995, legislation that would fundamentallyderegulate the industry was pending in Con-gress, and the broad form that new regulationswould take was fairly clear to most industryobservers. But whether or not the legislationwas going to pass and how quickly it would beimplemented in the event it did pass were un-certain. No amount of analysis would allowthe long-distance carriers to predict those out-comes, and the correct course of actionforexample, the timing of investments in networkinfrastructuredepended on which outcomeoccurred.

In another common level 2 situation, thevalue of a strategy depends mainly on compet-itors strategies, and those cannot yet be ob-

served or predicted. For example, in oligopolymarkets, such as those for pulp and paper,chemicals, and basic raw materials, the pri-mary uncertainty is often competitors plansfor expanding capacity: Will they build newplants or not? Economies of scale often dictatethat any plant built would be quite large andwould be likely to have a significant impact onindustry prices and profitability. Therefore,any one companys decision to build a plant isoften contingent on competitors decisions.This is a classic level 2 situation: The possibleoutcomes are discrete and clear. It is difficultto predict which one will occur. And the beststrategy depends on which one does occur.

Level 3: A Range of Futures.

At level 3, arange of potential futures can be identified.That range is defined by a limited number ofkey variables, but the actual outcome may lieanywhere along a continuum bounded by thatrange. There are no natural discrete scenarios.As in level 2, some, and possibly all, elementsof the strategy would change if the outcomewere predictable.

Companies in emerging industries or enter-ing new geographic markets often face level 3uncertainty. Consider a European consumer-goods company deciding whether to intro-duce its products to the Indian market. Thebest possible market research might identifyonly a broad range of potential customer-pene-tration ratessay, from 10% to 30%andthere would be no obvious scenarios withinthat range. Such a broad range of estimateswould be common when introducing com-pletely new products and services to a market,and therefore determining the level of latentdemand is very difficult. The company enter-ing India would be likely to follow a very dif-ferent and more aggressive entry strategy if itknew for certain that its customer penetrationrates would be closer to 30% than to 10%.

Analogous problems exist for companies infields driven by technological innovation, suchas the semiconductor industry. When decidingwhether to invest in a new technology, produc-ers can often estimate only a broad range ofpotential cost and performance attributes forthe technology, and the overall profitability ofthe investment depends on those attributes.

Level 4: True Ambiguity.

At level 4, multi-ple dimensions of uncertainty interact to cre-ate an environment that is virtually impossi-ble to predict. Unlike in level 3 situations, the

Under uncertainty, traditional approaches to strategic planning can be downright dangerous.



range of potential outcomes cannot be identi-fied, let alone scenarios within that range. Itmight not even be possible to identify, muchless predict, all the relevant variables that willdefine the future.

Level 4 situations are quite rare, and theytend to migrate toward one of the other levelsover time. Nevertheless, they do exist. Con-sider a telecommunications company decidingwhere and how to compete in the emergingconsumer-multimedia market. It is confront-ing multiple uncertainties concerning technol-ogy, demand, and relationships between hard-ware and content providers, all of which mayinteract in ways so unpredictable that no plau-sible range of scenarios can be identified.

Companies considering making major entryinvestments in post-Communist Russia in 1992faced level 4 uncertainty. They could not out-line the potential laws or regulations thatwould govern property rights and transactions.That central uncertainty was compounded byadditional uncertainty over the viability of

supply chains and the demand for previouslyunavailable consumer goods and services. Andshocks such as a political assassination or a cur-rency default could have spun the whole sys-tem toward completely unforeseen outcomes.

Those examples illustrate how difficult stra-tegic decisions can be at level 4, but they alsounderscore their transitory nature. Greater po-litical and regulatory stability has turned deci-sions about whether to enter Russian marketsinto level 3 problems for the majority of indus-tries today. Similarly, uncertainty about strate-gic decisions in the consumer multimedia mar-ket will migrate to level 3 or to level 2 as theindustry begins to take shape over the nextseveral years.

Tailoring Strategic Analysis to the Four Levels of Uncertainty

Our experience suggests that at least half of allstrategy problems fall into levels 2 or 3, whilemost of the rest are level 1 problems. But exec-utives who think about uncertainty in a binary

How to Usethe FourLevels ofUncertainty

A Clear-Enough Future

A single forecast precise enough for determining strategy

Traditional strategy tool kit

Strategy against low-cost airline entrant

What Can Be Known?

Analytic Tools

Examples

Alternate Futures

A few discrete outcomes that definethe future

Decision analysis Option valuation models Game theory

Long-distance telephone carriers strategyto enter deregulated local-service market

Capacity strategies for chemical plants

1

2

3



way tend to treat all strategy problems as ifthey fell into either level 1 or level 4. Andwhen those executives base their strategies onrigorous analysis, they are most likely to applythe same set of analytic tools regardless of thelevel of residual uncertainty they face. For ex-ample, they might attempt to use standard,quantitative market-research techniques toforecast demand for data traffic over wirelesscommunications networks as far out as tenyears from now.

But, in fact, a different kind of analysisshould be done to identify and evaluate strat-egy options at each level of uncertainty. Allstrategy making begins with some form of situ-ation analysisthat is, a picture of what theworld will look like today and what is likely tohappen in the future. Identifying the levels ofuncertainty thus helps define the best such ananalysis can do to describe each possible futurean industry faces.

To help generate level 1s usefully preciseprediction of the future, managers can use the

standard strategy tool kitmarket research,analyses of competitors costs and capacity,value chain analysis, Michael Porters five-forces framework, and so on. A discounted-cash-flow model that incorporates those pre-dictions can then be used to determine thevalue of various alternative strategies. Its notsurprising that most managers feel extremelycomfortable in level 1 situationsthese are thetools and frameworks taught in every leadingbusiness program in the United States.

Level 2 situations are a bit more complex.First, managers must develop a set of discretescenarios based on their understanding of howthe key residual uncertainties might playoutfor example, whether deregulation oc-curs or not, a competitor builds a new plant ornot. Each scenario may require a different val-uation modelgeneral industry structure andconduct will often be fundamentally differentdepending on which scenario occurs, so alter-native valuations cant be handled by perform-ing sensitivity analyses around a single base-

What Can Be Known?

Analytic Tools

Examples

A Range of Futures

A range of possible outcomes, but no natural scenarios

Latent-demand research Technology forecasting Scenario planning

Entering emerging markets, such as India Developing or acquiring emerging

technologies in consumer electronics

True Ambiguity

No basis to forecast the future

Analogies and pattern recognition Nonlinear dynamic models

Entering the market for consumer multi-media applications

Entering the Russian market in 1992

?



line model. Getting information that helpsestablish the relative probabilities of the alter-native outcomes should be a high priority.

After establishing an appropriate valuationmodel for each possible outcome and deter-mining how probable each is likely to be, aclassic decision-analysis framework can beused to evaluate the risks and returns inherentin alternative strategies. This process will iden-tify the likely winners and losers in alternativescenarios, and perhaps more important, it willhelp quantify whats at stake for companiesthat follow status quo strategies. Such an anal-ysis is often the key to making the case for stra-tegic change.

In level 2 situations, it is important not onlyto identify the different possible future out-comes but also to think through the likelypaths the industry might take to reach thosealternative futures. Will change occur in majorsteps at some particular point in time, follow-ing, for example, a regulatory ruling or a com-petitors decision to enter the market? Or willchange occur in a more evolutionary fashion,

as often happens after a resolution of compet-ing technology standards? This is vital infor-mation because it determines which marketsignals or trigger variables should be moni-tored closely. As events unfold and the relativeprobabilities of alternative scenarios change, itis likely that ones strategy will also need to beadapted to these changes.

At one level, the analysis in level 3 is verysimilar to that in level 2. A set of scenariosneeds to be identified that describes alterna-tive future outcomes, and analysis shouldfocus on the trigger events signaling that themarket is moving toward one or another sce-nario. Developing a meaningful set of scenar-ios, however, is less straightforward in level 3.Scenarios that describe the extreme points inthe range of possible outcomes are often rela-tively easy to develop, but these rarely providemuch concrete guidance for current strategicdecisions. Since there are no other natural dis-crete scenarios in level 3, deciding which possi-ble outcomes should be fully developed into al-ternative scenarios is a real art. But there are afew general rules. First, develop only a limitednumber of alternative scenariosthe com-plexity of juggling more than four or five tendsto hinder decision making. Second, avoid de-veloping redundant scenarios that have nounique implications for strategic decision mak-ing; make sure each scenario offers a distinctpicture of the industrys structure, conduct,and performance. Third, develop a set of sce-narios that collectively account for the

proba-ble

range of future outcomes and not necessar-ily the entire

possible

range.Because it is impossible in level 3 to define a

complete list of scenarios and related probabil-ities, it is impossible to calculate the expectedvalue of different strategies. However, estab-lishing the range of scenarios should allowmanagers to determine how robust their strat-egy is, identify likely winners and losers, anddetermine roughly the risk of following statusquo strategies.

Situation analysis at level 4 is even morequalitative. Still, it is critical to avoid the urgeto throw ones hands up and act purely on gutinstinct. Instead, managers need to catalog sys-tematically what they know and what is possi-ble to know. Even if it is impossible to developa meaningful set of probable, or even possible,outcomes in level 4 situations, managers cangain valuable strategic perspective. Usually,

Needed: A More Comprehensive Strategy Tool Kit

In order to perform the kinds of anal-yses appropriate to high levels of uncer-tainty, many companies will need to supplement their standard strategy tool kit. Scenario-planning techniques are fundamental to determining strategy under conditions of uncertainty. Game theory will help managers understand uncertainties based on competitors conduct. Systems dynamics and agent-based simulation models can help in un-derstanding the complex interactions in the market. Real-options valuation mod-els can help in correctly valuing invest-ments in learning and exibility. The fol-lowing sources will help managers get started:

Scenario Planning.

Kees van der Heijden,

Scenarios: The Art of Strategic

Conversation

(New York: John Wiley & Sons, 1996); Paul J.H. Schoemaker, Scenario Planning: A New Tool for Strategic Thinking,

Sloan Manage-

ment Review

, Winter 1995.

Game Theory.

Avinash K. Dixit and Barry J. Nalebuff,

Thinking Strategi-

cally: The Competitive Edge in Business,

Politics, and Everyday Life

(New York: W.W. Norton, 1991); Adam M. Bran-denburger and Barry J. Nalebuff, The Right Game: Use Game Theory to Shape Strategy, HBR JulyAugust 1995.

System Dynamics.

Peter N. Senge,

The Fifth Discipline: The Art and Prac-

tice of the Learning Organization

(New York: Doubleday, 1990); Arie de Geus, Planning as Learning, HBR MarchApril 1988.

Agent-Based Models.

John L. Casti,

Would-Be Worlds: How Simulation Is

Changing the Frontiers of Science

(New York: John Wiley & Sons, 1997).

Real Options.

Avinash K. Dixit and Robert S. Pindyck, The Options Ap-proach to Capital Investment, HBR MayJune 1995; Timothy A. Luehr-man, Whats It Worth? HBR MayJune 1997.



they can identify at least a subset of the vari-ables that will determine how the market willevolve over timefor example, customer pen-etration rates or technology performance at-tributes. And they can identify favorable andunfavorable indicators of these variables thatwill let them track the markets evolution overtime and adapt their strategy as new informa-tion becomes available.

Managers can also identify patterns indicat-ing possible ways the market may evolve bystudying how analogous markets developed inother level 4 situations, determining the key at-tributes of the winners and losers in those situ-ations and identifying the strategies they em-ployed. Finally, although it will be impossibleto quantify the risks and returns of differentstrategies, managers should be able to identifywhat information they would have to believeabout the future to justify the investmentsthey are considering. Early market indicatorsand analogies from similar markets will helpsort out whether such beliefs are realistic ornot.

Uncertainty demands a more exible ap-proach to situation analysis. The old one-size-ts-all approach is simply inadequate. Overtime, companies in most industries will facestrategy problems that have varying levels ofresidual uncertainty, and it is vitally importantthat the strategic analysis be tailored to thelevel of uncertainty.

Postures and Moves

Before we can talk about the dynamics of for-mulating strategy at each level of uncertainty,we need to introduce a basic vocabulary fortalking about strategy. First, there are three

strategic postures

a company can choose totake vis--vis uncertainty: shaping, adapting,or reserving the right to play. Second, thereare three types of moves in

the portfolio of ac-tions

that can be used to implement that strat-egy: big bets, options, and no-regrets moves.

Strategic Posture.

Any good strategy re-quires a choice about strategic posture. Funda-mentally,

posture

defines the intent of a strat-egy relative to the current and future state ofan industry.

Shapers

aim to drive their indus-tries toward a new structure of their own devis-ing. Their strategies are about creating new op-portunities in a marketeither by shaking uprelatively stable level 1 industries or by trying tocontrol the direction of the market in indus-tries with higher levels of uncertainty. Kodak,for example, through its investment in digitalphotography, is pursuing a shaping strategy inan effort to maintain its leadership position, asa new technology supersedes the one currentlygenerating most of its earnings. Although itsproduct technology is new, Kodaks strategy isstill based on a traditional model in which thecompany provides digital cameras and filmwhile photo-processing stores provide many ofthe photo-printing and storage functions for

The Three Strategic Postures

Shape the futurePlay a leadership role inestablishing how the industryoperates, for example:

setting standards creating demand

Reserve the right to playInvest sufficiently to stay in thegame but avoid premature commitments

Adapt to the futureWin through speed, agility, andflexibility in recognizing and capturing opportunities inexisting markets



the consumer. Hewlett-Packard also seeks to bea shaper in this market, but it is pursuing a rad-ically different model in which high-quality,low-cost photo printers shift photo processingfrom stores to the home.

In contrast,

adapters

take the current indus-try structure and its future evolution as givens,and they react to the opportunities the marketoffers. In environments with little uncer-tainty, adapters choose a strategic position-ingthat is, where and how to competeinthe current industry. At higher levels of uncer-tainty, their strategies are predicated on theability to recognize and respond quickly tomarket developments. In the highly volatiletelecommunications-service industry, for ex-ample, service resellers are adapters. They buyand resell the latest products and services of-fered by the major telecom providers, relyingon pricing and effective execution rather thanon product innovation as their source of com-petitive advantage.

The third strategic posture,

reserving theright to play,

is a special form of adapting. Thisposture is relevant only in levels 2 through 4; itinvolves making incremental investmentstoday that put a company in a privileged posi-tion, through either superior information, coststructures, or relationships between custom-ers and suppliers. That allows the company towait until the environment becomes less un-certain before formulating a strategy. Many

pharmaceutical companies are reserving theright to play in the market for gene therapyapplications by acquiring or allying with smallbiotech firms that have relevant expertise. Pro-viding privileged access to the latest industrydevelopments, these are low-cost investmentscompared with building a proprietary, internalgene-therapy R&D program.

A Portfolio of Actions.

A posture is not acomplete strategy. It clarifies strategic intentbut not the actions required to fulfill that in-tent. Three types of moves are especially rele-vant to implementing strategy under condi-tions of uncertainty: big bets, options, and no-regrets moves.

Big bets

are large commitments, such asmajor capital investments or acquisitions, thatwill result in large payoffs in some scenariosand large losses in others. Not surprisingly,shaping strategies usually involve big bets,whereas adapting and reserving the right toplay do not.

Options

are designed to secure the big pay-offs of the best-case scenarios while minimiz-ing losses in the worst-case scenarios. Thisasymmetric payoff structure makes them re-semble financial options. Most options in-volve making modest initial investments thatwill allow companies to ramp up or scale backthe investment later as the market evolves.Classic examples include conducting pilot tri-als before the full-scale introduction of a new

Whats in a Portfolio of Actions?These building blocks are distinguished by three payoff profiles that is, the amount of investmentrequired up front and the conditions under which the investment will yield a positive return.

No-regrets movesStrategic decisions that havepositive payoffs in any scenario

OptionsDecisions that yield a significant positive payoff in some outcomesand a (small) negative effect in others

Big betsFocused strategies with positive payoffs in one or more scenarios but a negative effect in others

Scenario

1.

2.

3.

4.

Value

+

+

+

+



product, entering into limited joint venturesfor distribution to minimize the risk of break-ing into new markets, and licensing an alterna-tive technology in case it proves to be superiorto a current technology. Those reserving theright to play rely heavily on options, butshapers use them as well, either to shape anemerging but uncertain market as an earlymover or to hedge their big bets.

Finally,

no-regrets moves

are just thatmoves that will pay off no matter what hap-pens. Managers often focus on obvious no-re-grets moves like initiatives aimed at reducingcosts, gathering competitive intelligence, orbuilding skills. However, even in highly uncer-tain environments, strategic decisions like in-vesting in capacity and entering certain mar-kets can be no-regrets moves. Whether or notthey put a name to them, most managers un-derstand intuitively that no-regrets moves arean essential element of any strategy.

The choice of a strategic posture and an ac-companying portfolio of actions soundsstraightforward. But in practice, these deci-sions are highly dependent on the level of un-certainty facing a given business. Thus thefour-level framework can help clarify thepractical implications implicit in any choiceof strategic posture and actions. The discus-sion that follows will demonstrate the differ-ent strategic challenges that each level of un-certainty poses and how the portfolio ofactions may be applied.

Strategy in Level 1s Clear-Enough Future.

In predictable business environments, mostcompanies are adapters. Analysis is designedto predict an industrys future landscape, andstrategy involves making positioning choicesabout where and how to compete. When theunderlying analysis is sound, such strategiesare by definition made up of a series of no-re-grets moves.

Adapter strategies in level 1 situations arenot necessarily incremental or boring. For ex-ample, Southwest Airlines Companys no-frills,point-to-point service is a highly innovative,value-creating adapter strategy, as was Gate-way 2000s low-cost assembly and direct-maildistribution strategy when it entered the per-sonal computer market in the late 1980s. Inboth cases, managers were able to identify un-exploited opportunities in relatively low-un-certainty environments within the existingmarket structure. The best level 1 adapters cre-

ate value through innovations in their prod-ucts or services or through improvements intheir business systems without otherwise fun-damentally changing the industry.

It is also possible to be a shaper in level 1 sit-uations, but that is risky and rare, since level 1shapers increase the amount of residual uncer-tainty in an otherwise predictable marketforthemselves and their competitorsin an at-tempt to fundamentally alter long-standing in-dustry structures and conduct. Consider Fed-eral Express Corporations overnight-deliverystrategy. When it entered the mail-and-pack-age delivery industry, a stable level 1 situation,FedExs strategy in effect created level 3 uncer-tainty for itself. That is, even though CEO Fre-derick W. Smith commissioned detailed con-sulting reports that confirmed the feasibility ofhis business concept, only a broad range of po-tential demand for overnight services could beidentified at the time. For the industry incum-bents like United Parcel Service, FedEx createdlevel 2 uncertainty. FedExs move raised twoquestions for UPS: Will the overnight-deliverystrategy succeed or not? and Will UPS have tooffer a similar service to remain a viable com-petitor in the market?

Over time, the industry returned to level 1stability, but with a fundamentally new struc-ture. FedExs bet paid off, forcing the rest ofthe industry to adapt to the new demand forovernight services.

What portfolio of actions did it take to real-ize that strategy? Like most shaper strategies,even in level 1 situations, this one requiredsome big bets. That said, it often makes senseto build options into a shaper strategy to hedgeagainst bad bets. Smith might have hedged hisbets by leasing existing cargo airplanes insteadof purchasing and retrofitting his original fleetof Falcon minifreighters, or he could haveoutsourced ground pickup and delivery ser-vices. Such moves would have limited theamount of capital he would have needed tosink into his new strategy and facilitated agraceful exit had his concept failed. However,that kind of insurance doesnt always comecheap. In FedExs case, had Smith leased stan-dard-size cargo planes, he would have comeunder the restrictive regulations of the CivilAeronautics Board. And outsourcing localpickups and deliveries would have diluted Fe-dExs unique door-to-door value to customers.Thus Smith stuck mainly to big bets in imple-

The old one-size-fits-all analytic approach to evaluating strategy options is simply inadequate.



menting his strategy, which drove him to thebrink of bankruptcy in his first two years of op-eration but ultimately reshaped an entire in-dustry.

Strategy in Level 2s Alternate Futures.

Ifshapers in level 1 try to raise uncertainty, inlevels 2 through 4 they try to lower uncer-tainty and create order out of chaos. In level 2,a shaping strategy is designed to increase theprobability that a favored industry scenariowill occur. A shaper in a capital-intensive in-dustry like pulp and paper, for example, wantsto prevent competitors from creating excesscapacity that would destroy the industrysprofitability. Consequently, shapers in suchcases might commit their companies to build-ing new capacity far in advance of an upturnin demand to preempt the competition, orthey might consolidate the industry throughmergers and acquisitions.

Consider the Microsoft Network (MSN). Afew years ago, one could identify a discrete setof possible ways in which transactions wouldbe conducted between networked computers.Either proprietary networks such as MSNwould become the standard, or open networkslike the Internet would prevail. Uncertainty inthis situation was thus at level 2, even thoughother related strategy issuessuch as deter-mining the level of consumer demand for net-worked applicationswere level 3 problems.

Microsoft could reasonably expect to shapethe way markets for electronic commerceevolved if it created the proprietary MSN net-work. It would, in effect, be building a com-merce hub that would link both suppliers andconsumers through the MSN gateway. Thestrategy was a big bet: the development costswere signicant and, more important, involvedan enormously high level of industry exposureand attention. In effect, for Microsoft, it consti-tuted a big credibility bet. Microsofts activitiesin other areassuch as including one-buttonaccess to MSN from Windows95were de-signed to increase the probability that thisshaping bet would pay off.

But even the best shapers must be preparedto adapt. In the battle between proprietary andopen networks, certain trigger variablesgrowth in the number of Internet and MSNsubscribers, for example, or the activity prolesof early MSN subscriberscould provide valu-able insight into how the market was evolving .When it became clear that open networks

would prevail, Microsoft refocused the MSNconcept around the Internet. Microsofts shiftillustrates that choices of strategic posture arenot carved in stone, and it underscores thevalue of maintaining strategic exibility underuncertainty. Shaping strategies can fail, so thebest companies supplement their shaping betswith options that allow them to change coursequickly if necessary. Microsoft was able to dojust that because it remained exible by beingwilling to cut its losses, by building a cadre ofengineers who had a wide range of general-programming and product-development skills,and by closely monitoring key trigger vari-ables. In uncertain environments, it is a mis-take to let strategies run on autopilot, remain-ing content to update them only throughstandard year-end strategy reviews.

Because trigger variables are often relativelysimple to monitor in level 2, it can be easy toadapt or reserve the right to play. For instance,companies that generate electricityand oth-ers whose business depends on energy-inten-sive production processesoften face level 2uncertainty in determining the relative cost ofdifferent fuel alternatives. Discrete scenarioscan often be identiedfor example, eithernatural gas or oil will be the low-cost fuel.Many companies thus choose an adapter strat-egy when building new plants: they constructexible manufacturing processes that canswitch easily between different fuels.

Chemical companies often choose to re-serve the right to play when facing level 2 un-certainty in predicting the performance of anew technology. If the technology performswell, companies will have to employ it to re-main competitive in the market. But if it doesnot fulll its promise, incumbents can competeeffectively with existing technologies. Mostcompanies are reluctant to bet several hundredmillion dollars on building new capacity andretrotting old plants around a new technol-ogy until it is proven. But if they dont make atleast incremental investments in the short run,they risk falling too far behind competitorsshould the technology succeed. Thus manywill purchase options to license the new tech-nology within a specied time frame or beginretrotting a proportion of existing capacityaround the new technology. In either case,small, up-front commitments give the compa-nies privileged positions, but not obligations,to ramp up or discontinue development of the

Shaping strategies can fail, so the best companies supplement their shaping bets with options that let them change course quickly.



new technology as its performance attributesbecome clearer over time.

Strategy in Level 3s Range of Futures.

Shaping takes a different form in level 3. If atlevel 2, shapers are trying to make a discreteoutcome occur, at level 3, they are trying tomove the market in a general direction be-cause they can identify only a range of possi-ble outcomes. Consider the battle over stan-dards for electronic cash transactions,currently a level 3 problem since one can de-fine a range of potential products and servicesthat fall between purely paper-based andpurely electronic cash transactions, but it isunclear today whether there are any natural

discrete scenarios within that range. MondexInternational, a consortium of financial ser-vices providers and technology companies, isattempting to shape the future by establishingwhat it hopes will become universal elec-tronic-cash standards. Its shaping posture isbacked by big-bet investments in product de-velopment, infrastructure, and pilot experi-ments to speed customer acceptance.

In contrast, regional banks are mainly choos-ing adapter strategies. An adapter posture atuncertainty levels 3 or 4 is often achieved pri-marily through investments in organizationalcapabilities designed to keep options open. Be-cause they must make and implement strategy

How a Regional Bank Confronts the Uncertainties in Electronic Commerce

1.Identify the nature and extent of residual uncertainties

Key areas of uncertainty include

:

How much electronic commerce will occur on the Internet

How quickly consumers will switch from paper-based to electronic payments

Which specic instruments will become the primary payment vehicles (smart cards? E-cash?)

What structure will emerge for the elec-tronic commerce industry

How vertically integrated most players will be

What roles banks and nonbanks will play

The bank is facing level 3 uncertainty in

some areas and level 4 in others

2.Choose a strategic posture

Objectives:

Defend current customer franchise from at-tack by new technology-based competitors

Capture new business opportunities in fast growing markets

Overall posture: reserve the right to play

3.Build a portfolio of actions

Near-term opportunities to offer more

innovative products in specic areas

where the bank is strong (for example,

procurement cards, industry-specic

payment products) represent no-re-

grets moves.

Offering leading-edge payment prod-

ucts to high-value customer segments

that are most vulnerable to attackers is

another no-regrets move.

Forming a small new-business unit is

a growth option to:

Conduct R&D for new payment ideas

Monitor industry developments in the broad area of retail electronic payments

4. Actively manage the strategy

Monitor key trigger events such as

adoption rates for emerging products

and the behavior of nontraditional com-

petitors such as telephone companies.

Establish a short-cycle review of the

portfolio of options.

Participate in a number of industry

consortia to reduce uncertainty.

Actively manage the strategy Identify the

nature and extent of residualuncertainties

Build a portfolio of actions

Choose a strategicposture

4

2

1

3



choices in real time, adapters need quick accessto the best market information and the mostexible organizational structures. Many re-gional banks, for example, have put in placesteering committees focused on electronic pay-ments, R&D projects, and competitive-intelli-gence systems so that they can constantly moni-tor developments in electronic paymenttechnology and markets. In addition, many re-gional banks are making small investments inindustry consortia as another way to monitorevents. This adapter approach makes sense formost regional banksthey dont have the deeppockets and skills necessary to set standards forthe electronic payment market, yet it is essen-tial that they be able to offer the latest elec-tronic services to their customers as such ser-vices become available.

Reserving the right to play is a common pos-ture in level 3. Consider a telecommunicationscompany trying to decide whether to make a $1billion investment in broadband cable net-works in the early 1990s. The decision hingedon level 3 uncertainties such as demand for in-teractive TV service. No amount of solid mar-ket research could precisely forecast consumerdemand for services that didnt even exist yet.However, making incremental investments inbroadband-network trials could provide usefulinformation, and it would put the company in aprivileged position to expand the business inthe future should that prove attractive. By re-structuring the broadband-investment decisionfrom a big bet to a series of options, the com-pany reserved the right to play in a potentiallylucrative market without having to bet thefarm or risk being preempted by a competitor.

Strategy in Level 4s True Ambiguity.

Para-doxically, even though level 4 situations con-tain the greatest uncertainty, they may offerhigher returns and involve lower risks for com-panies seeking to shape the market than situa-tions in either level 2 or 3. Recall that level 4situations are transitional by nature, often oc-curring after a major technological, macroeco-nomic, or legislative shock. Since no playernecessarily knows the best strategy in theseenvironments, the shapers role is to provide avision of an industry structure and standardsthat will coordinate the strategies of otherplayers and drive the market toward a morestable and favorable outcome.

Mahathir bin Mohamad, Malaysias primeminister, is trying to shape the future of the

multimedia industry in the Asian Pacic Rim.This is truly a level 4 strategy problem at thispoint. Potential products are undened, as arethe players, the level of customer demand, andthe technology standards, among other factors.The government is trying to create order out ofthis chaos by investing at least $15 billion tocreate a so-called Multimedia Super Corridor(MSC) in Malaysia. The MSC is a 750-square-ki-lometer zone south of Kuala Lumpur that willinclude state-of-the-art smart buildings forsoftware companies, regional headquarters formultinational corporations, a MultimediaUniversity, a paperless government centercalled Putrajaya, and a new city called Cyber-jaya. By leveraging incentives like a ten-yearexemption from the tax on prots, the MSChas received commitments from more than 40Malaysian and foreign companies so far, in-cluding such powerhouses as Intel, Microsoft,Nippon Telegraph and Telephone, Oracle, andSun Microsystems. Mahathirs shaping strategyis predicated on the notion that the MSC willcreate a web of relationships between contentand hardware providers that will result in clearindustry standards and a set of complementarymultimedia products and services. Intels Ma-laysia managing director, David B. Marsing,recognized Mahathirs shaping aspirationswhen he noted, If youre an evolutionist, itsstrange. Theyre [the Malaysian government]trying to intervene instead of letting it evolve.

Shapers need not make enormous bets asthe Malaysian government is doing to be suc-cessful in level 3 or 4 situations, however. Allthat is required is the credibility to coordinatethe strategies of different players around thepreferred outcome. Netscape Communica-tions Corporation, for example, didnt rely ondeep pockets to shape Internet browser stan-dards. Instead, it leveraged the credibility of itsleadership team in the industry so that otherindustry players thought, If these guys thinkthis is the way to go, they must be right.

Reserving the right to play is common, butpotentially dangerous, in level 4 situations.Oil companies believed they were reservingthe right to compete in China by buying op-tions to establish various beachheads theresome 20 years ago. However, in such level 4situations, it is extremely difcult to deter-mine whether incremental investments aretruly reserving the right to play or simply theright to lose. A few general rules apply. First,

Netscape relied on its credibility rather than deep pockets, to shape Internet browser standards.



look for a high degree of leverage. If thechoice of beachhead in China comes down tomaintaining a small, but expensive, local op-eration or developing a limited joint venturewith a local distributor, all else being equal,go for the low-cost option. Higher-cost op-tions must be justied with explicit argu-ments for why they would put the companyin a better position to ramp up over time. Sec-ond, dont get locked into one positionthrough neglect. Options should be rigorouslyreevaluated whenever important uncertain-ties are clariedat least every six months.Remember, level 4 situations are transitional,and most will quickly move toward levels 3and 2.

The difculty of managing options in level4 situations often drives players towardadapter postures. As in level 3, an adapterposture in level 4 is frequently implementedby making investments in organizational ca-pabilities. Most potential players in the multi-media industry are adopting that posturetoday but will soon be making bigger bets asthe industry moves into level 3 and 2 uncer-tainty over time.

A New Approach to UncertaintyAt the heart of the traditional approach tostrategy lies the assumption that by applying aset of powerful analytic tools, executives canpredict the future of any business accurately

enough to allow them to choose a clear strate-gic direction. In relatively stable businesses,that approach continues to work well. But ittends to break down when the environment isso uncertain that no amount of good analysiswill allow them to predict the future.

Levels of uncertainty regularly confrontingmanagers today are so high that they need anew way to think about strategy. The approachweve outlined will help executives avoid dan-gerous binary views of uncertainty. It offers adiscipline for thinking rigorously and systemat-ically about uncertainty. On one plane, it is aguide to judging which analytic tools can helpin making decisions at various levels of uncer-tainty and which cannot. On a broader plane,our framework is a way to tackle the most chal-lenging decisions that executives have to make,offering a more complete and sophisticatedunderstanding of the uncertainty they face andits implications for strategy.

This article is based on research sponsored byMcKinseys ongoing Strategy Theory Initiative(STI). The authors would like to thank their STIcolleagues for their significant contributions tothis article.

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page 15

Further ReadingA R T I C L E SStrategies That Fit Emerging Marketsby Tarun Khanna, Krishna G. Palepu, and Jayant SinhaHarvard Business ReviewJune 2005Product no. R0506C

The authors present an analytical approach to assessing the particularly profound un-certainty inherent in emerging markets. They advocate understanding institutional variations between countriesby comparing countries political and social systems; their degree of openness; and their product, labor, and capital markets. By asking a series of ques-tions pertaining to each of these areas, you can map any nations institutional contexts. When you match your strategies to each countrys contexts, you can take advantage of a locations unique strengths. But first weigh the benefits against the costs. If you find that the risks of adaptation are too great, try to change the contexts in which you operateor simply stay away.

Predictable Surprises: The Disasters You Should Have Seen Comingby Michael D. Watkins and Max H. BazermanHarvard Business ReviewApril 2003Product no. R0303E

Some potential upheavals in the markets in which you operate can be anticipatedtheyre predictable surprises. These disasters take many forms, from financial scandals to disruptions in operations, from organizational upheavals to product failures. All companies are vulnerable to predictable surprises. But re-cent research helps explain how to minimize your risk. Organizations inability to prepare for predictable surprises can be traced to three sets of vulnerabilities: psychological, organiza-tional, and political. To address these vulnera-bilities, use more than just environmental scanning and contingency planning; also ad-here to a chain of actions: recognizing, priori-tizing, and mobilizing (RPM). Failure to apply any one of the RPM steps can leave your orga-nization vulnerable.

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