Why you should take bigger risks
By: Samuel G. Smith
Tags: Venture Capital, Risk Taking, Risk Management, Risk, Ambition

THINKING ABOUT RISK

How do we define risk?

Dictionary definitions classify risk as an exposure to danger, harm or loss, but this does little to discuss the probabilities and potentiality behind risk endowed events.

Finance professionals are amongst those who have tried to quantify risk by linking it to the volatility of stock returns. The logic assumes that one any given day, the returns on a stock are random, with probabilities spread across a standard distribution curve, creating a linear risk profile for the returns. Hence, their definition of risk is inherently statistical, and the linearity of returns poses a tradeoff scenario, where it’s assumed returns cannot be increased without also increase risk.

There are, however, fallacies with this assumption, that fail to create an accurate model with applications outside of the niche sector of investment management. Let’s take the measure of volatility. High volatility means is the price of a stock fluctuates greatly upwards, downwards, or in a wave. Low volatility conversely means there is little movement in the price of the stock, which is linked to little risk in the stock. This is inherently not true. Volatile assets are not necessarily risky, the risk lays in the underlying asset, and whether or not the asset has a significant probability of leading to ruin. A non-volatile asset may comparatively be risky, if there exist possibilities that the asset could face extreme outflows, or fall to zero contingent on an event occurring. So, while I’m not saying volatility is utterly redundant as a measure of risk, it’s not a comprehensive measure of risk, especially outside of investment management.

Non-linearity of risk

Again, we are quashing the assumptions that finance literature has provided us with, to get a more detailed understanding of the reality behind risk. As mentioned, volatility leads into the discussion of risk in a linear relationship with reward, i.e. for every 10% increase in risk, our expected value (of payoff) increases by 10%.

However, I propose that this is not the case. Risks are very rarely binary, with static win-loss outcomes. In most cases, risks involve a consortium of factors, creating complexity around the situation, thereby creating non-linearity in the outcomes. This, for example, can lead onto 10x, 100x, or 1000x returns to the upside, or a downward spiral when things take a turn for the worst, bringing us onto the next topic for discussion.

Size matters…

Despite what some may say in other area’s of life, when it comes to risk, size DOES matter. We accept the notion, ‘it’s not about how often one is right, but rather the magnitude of the payoff when one is right.’ Take an investing example. It doesn’t matter how many of the investor’s stock’s make them money, but rather the amount that the investments generate in absolute terms.

Investing analogies are quite conceptually easy when thinking of risk. So to further justify the importance of size, we have an example in the world of politics from Naseem Talib, in his book Skin in the Game. When it comes to public policy, intolerant minorities can (and will) destroy tolerant majorities. The potential size of the impact is more important than the likelihood of the result, especially when the impact could be detrimental (deadly) to the agent involved.

Leading on from this, is the discussion of differentiating risk — ruin & failure. In his book Anti-Fragile, Talib discusses the distinction at length, but effectively it comes down to; does this action contain the possibility of minor harm, or death? We must avoid situations involving low (or any) probability of death at all costs, because no matter how low the odds, there is no recovery from a ‘ruin’ outcome. Contrast this with the risk of failure. Amazon encourages its firm to try, and fail in numerous projects, so long as they won’t cause structural issues (ruin) to the firm.

Embrace being wrong when it’s not costly, and doesn’t count. Trial and error is an integral part of development, be that personal or product, which allows you to take directional steps forward, rather than comically walking back and forth until the ground slowly wears away beneath your feet.