Risky Business – 4 Keys to Understanding Risk

Apr 4, 2020 3:40 AM ET

Several years ago, I gave a talk at which I told the story about starting my own company, stepping out on my own, taking on millions of dollars in personally guaranteed debt, and staking my young family’s future on the success of my new company.

During the talk I explained that if you look up the word “entrepreneur” in the dictionary you will see that it is defined as one who “initiates and takes risk.” Then someone in the audience asked: “How did you justify taking the risk of starting your own company?”

My answer was this: through experience, I had become confident in my ability to take, manage, and mitigate risks. I was less worried about having my future be in my own hands than I was having it in the hands of someone else.

As a business owner, understanding risk is critical. Here are four business principles that will get you there:

1. Profit Margin

I once had a good friend who owned a large chain of grocery stores. In the grocery business, profit margins are very low, typically in the 1-2% of revenue range. In other words, you have to sell $1 million worth of groceries to make a profit of $10,000-$20,000, which makes for a high cost, low margin, high-risk business.

When Walmart and Amazon decided to get into the grocery business in Phoenix, my friend had to compete with them and his narrow margin turned negative, forcing his business into bankruptcy. With margins so small, his business just had no room for any unexpected changes. The rewards no longer justified the risks.

Probably the easiest way to measure the risk of a business decision is to evaluate the “profit margin” that we expect to achieve versus the “risk” (exposure to loss) that we might encounter. In the homebuilding business, before we would commit to buying land for a new project, we would calculate the realistic revenues and costs to determine the expected profit margin. Usually this margin would be between 5% and 10%. The higher the expected profit margin, the lower the risk. Anything under 5% was out, and anything over 10% was a go. But if it was between 5% and 10% we had to dig deeper into the details to see how we could get to an expected profit margin of 10%. If we could, we would move forward. If not, we would pass.

2. Margin of Safety

Before you buy in to a risky venture, you need to do your homework to uncover all of the possible things that could go wrong. Once you have done this, you can be better prepared to understand and deal with any adversity that comes your way.

To understand the concept of “margin of safety,” ask yourself what you stand to lose, and how much is safe? If you’re playing blackjack in Las Vegas and put $100 on the table, you stand to lose it all, so your margin of safety is zero. If you are investing in a stock, your safety margin is probably in the 80% range, and gets much better the longer you hold it.

When the housing market in Phoenix crashed and prices dropped more than 50%, shrewd investors quietly bought thousands of houses, some for as little as $30,000, and leased them to people who were afraid to buy. Five years later, these investors were able to sell these houses for big gains. Why did they take this risk? When they looked at the bet they were taking, they could see that prices had already fallen well below replacement costs and couldn’t fall much more. And if they did, it would probably be less than 20%, so their margin of safety was at least 80%.

Because they could easily cover their holding costs by renting the homes until the market recovered, and their margin of safety was 80%, they could see that this was a very safe risk, and they capitalized on the opportunity.

3. Return on Investment

Probably the most basic way to look at risk is with the “return on investment” or ROI principle. In financial markets, the expected returns are based on the perceived risks in each investment category. For example, the expected annual returns for 5-10-year bonds are in the 3% range, while the expected annual returns for most stocks are in the 6-8% range, as they are more volatile. The point here is that your return must be relative to your risk. The bigger your risk, the bigger your return should be, and the potential benefits must exceed the potential costs.

As a partner with Trammell Crow Residential in the 1980s, we had a very simple way of managing risk. We knew that if things went badly we would lose 100% of our investment. So to justify this risk we tried to achieve at least ten times our investment. This was a high mark that we rarely hit, but it helped us stay out of trouble.

4. Volatility

The “Sharpe ratio” was developed in 1966 to address volatility in the stock market (standard deviation) as a risk that required investors to seek higher returns. The concept here is that higher volatility (large swings in value) creates more risk that should be rewarded in the long run by higher returns. The more stable the investment, the lower the volatility, the lower the risk, and the lower the expected return.

The higher the Sharpe ratio, the more return investors can expect to receive in return for the extra volatility they are exposed to. The Sharpe ratio message is clear: change, uncertainty, and volatility all provide opportunities for taking smart risks that earn higher returns.

You can’t go through life without taking risks, so be the person who strives, who takes smart risks, and gives it your all. And when you lose, as you sometimes will, get right back up and into the arena. That’s a life without regrets and a life worth living.

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