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The Risk Discount

Posted on 5.06.2007
How the Perception of Risk Costs e-Retailers Money Every Day


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When consumers feel that the Internet is not a safe place to do business, they become anxious. Regardless of whether this fear is warranted, the effect on online retailers is daunting. Needless to say, consumer anxiety creates a complicated challenge for online merchants, especially Internet retailers without national, trusted brands. This lack of consumer confidence has created a phenomenon in online retailing – The Risk Discount. Simply put, the Risk Discount affirms that buyers who perceive risk when making a purchase will discount the price they are willing to pay.

A great deal of evidence—ranging from academic research to anecdotal evidence and buySAFE Merchant experiences supports this conclusion. A June 2005 report issued by the investment firm of Piper Jaffray concluded that “respected branded sellers are pulling the large numbers of fraud-averse online shoppers away” from lesser known sellers, and that remaining buyers “are applying what amounts to a ‘fraud discount’” and forcing prices lower(1).  In an increasingly anxious online marketplace, success for Internet merchants depends more and more on how well they counter the Risk Discount.

Risk . . . and the Perception of Risk

The majority of online merchants take steps to represent themselves in a credible and trustworthy fashion. However, some fraudulent sellers have created scams worthy of prominent media attention. While data security is a threat, poor merchant performance consistently and overwhelmingly represents the greatest risk to internet users. In fact, the National Consumer League’s 2006 Top 10 Internet Scam Trends reported that merchant non-performance - more specifically, non-delivery or misrepresentation of goods - made up 67% of all reported Internet scams as reported(2). Clearly, online buyers’ fear of being scammed and merchant non-performance cost legitimate merchants billions of dollars in lost sales annually. This perceived risk has caused the trustworthiness of merchant to surpass all other factors – even price – as the most important factor in a buyer’s decision to make a purchase online.

Buyers perceive risk in a transaction because they have limited knowledge of the seller’s ability and willingness to perform. In other words, buyers don’t know as much about online merchants as they need to know in order to feel comfortable. Fundamentally, a merchant must reduce or even eliminate the perception of risk before, during, and after the shopping experience. In an eCommerce environment, addressing risk at every step of the buying process is essential to distinguishing trustworthy, reliable merchants.

The Relationship Between Risk and Return in Online Shopping

A significant body of literature in the field of economics discusses the relationship between risk and return (Sharpe, Miller & Modigliani, etc.). As any investor will tell you, a greater risk is attractive only if it offers a greater return. Studies that examine the relationship between risk and pricing in online transactions have consistently found a similar relationship. Online shoppers seek to compensate for greater risk by decreasing the price they will pay.

you can see the Risk Discount principle at work by doing a simple search with almost any major comparison shopping engine. A recent search for the Sony Cyber-Shot DSC T30 Digital Camera on Shopzilla vividly illustrates the difference in average prices for well-known retailers and lesser-known merchants. In this example, the average price of the camera from a well-known e-retailer was $69 – or 17.6% - more than that of a lesser-know online merchant. This clearly shows that lesser known retailers must sell their items at a significantly lower price just to compete with larger online brands.

While the Risk Discount phenomenon leads buyers to discount the prices they are willing to pay, the Trust Premium is the complete opposite. Buyers who discount the prices they are willing to pay in high-risk transactions will pay a premium for low-risk transactions. That is why buyers are willing to pay well-known online retailers more for an identical product than they are willing to pay a lesser-known Internet merchant. This is called the “Trust Premium” and it is the inverse of the Risk Discount. For small to mid-sized online merchants, turning the Risk Discount into a Trust Premium has never been more critical to profitability.

Eliminating the Risk Discount, and Earning a Trust PremiumMany shoppers find security in well-known brands. They will shop—and buy—in the online stores of national brands but will not buy from smaller online retailers because they feel that they do not know them, that they do not know what to expect from them, or that they have “never heard of them.”

For most retailers, building or buying a national brand name is prohibitively expensive. Therefore, Internet retailers need an alternative strategy. Perhaps the most effective strategy is to have an objective, trusted third-party institution endorse the retailer’s business with both its own trusted brand as well as its financial resources. The third-party’s endorsement and financial guarantees can enable online merchants to compete more effectively with established, well-branded, online retailers. Shoppers who have come to respect and trust the third party’s brand will know that they can trust the retailers who are permitted to use it.

buySAFE - A Proven Solution to the Risk DiscountThis is the idea behind buySAFE; the company I founded while earning my MBA at The Wharton School, University of Pennsylvania. I wanted to create a solution that would clearly distinguish the best online merchants – regardless of size – and provide a purchase guarantee to convert the most risk-averse shoppers. In other words, I wanted to provide a solution that would help small to mid-sized merchants turn the Risk Discount into a Trust Premium. That solution is buySAFE.

In over 12 million bonded transactions to date, buySAFE has been proven to increase buyer confidence. We accomplish this by providing our certified merchants with the buySAFE Seal for display on their website and by enabling shoppers to guarantee their purchase with a bond guarantee from buySAFE’s surety partners - Liberty Mutual®, Travelers®, and ACE USA®. In so doing, buySAFE also benefits merchants because shoppers are more likely to buy when they have trust and confidence that the merchant will perform as promised. With increased buyer confidence, buySAFE Merchants typically enjoy the Trust Premium - higher website conversion, more repeat buyers and a better ROI on all their marketing dollars.

About the Author
Steven L. Woda is buySAFE’s founder and Chairman. Steve continues to lead the strategic development of buySAFE to fulfill the vision of making every online transaction safe, reliable, and virtually risk-free.

Footnotes:
1 Piper Jaffray Report – June 27, 2005
2 National Consumer League Fraud Center’s 2006 Top 10 Internet Scams (http://fraud.org/stats/2006/internet.pdf)
3 Online Shopper Survey – August, 20064 Average Online Price Comparison Study – August 28, 2006

4 Average Online Price Comparison Study – August 28, 2006
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