Measuring Risk, Weighing Unicorns, and Betting the Farm

Measuring risk is an oxymoron.  Unicorns are mythical creatures that do not [likely] exist, and hence can’t be weighed.  ‘Betting the farm’ is a metaphor for making an extremely large [if not excessive] bet; typically presumed to be risky.  The three notions meld together seamlessly; we can measure risk until we can’t, we can’t measure (weigh) what doesn’t exist [or we can’t find], and we like to make big bets.  But other than in very specific situations (e.g. you can count cards or are otherwise talented, or you got lucky) we’re not good at understanding risk or making good bets more than intermittently – and can’t identify situations when the ‘one time we were wrong’ could hurt worse than all of the times we were right (e.g. I win $1 ten bets in a row, and on my eleventh bet I lose $1000) combined.

But, how much would a Unicorn weigh?

Whether we’re talking sports betting, fantasy sports, stocks, bonds, new businesses, movie productions, or book sales, there is an inherent underestimation of the risks involved in such endeavors.  I’m told that Venture Capitalists, statistically, fare much better than their entrepreneur counterparts.  I am not surprised.  Roughly 90% of new businesses in the US fail (historically – now, who knows?) but, when they work, lookout!!! (See Google)

The point is, in investing in new companies for example, that we could over or under-estimate the risks involved.  Then we might be either unwilling to invest at all in fear of  ‘the odds’ or overly eager to invest because of how huge the ‘payoff’ might be.  Thankfully in the US we don’t have as many people in the ‘unwilling’ camp (historically) and, on the global scene, we’re viewed as the world’s risk takers – i.e. the innovators.  The problem?  As a people, we are not VC firms.  We do not spread a vast number of diversified, yet calculated, risky bets across a wide enough spectrum that we can achieve some margin of safety (and we don’t have the cash to play again to win it back).

How much for the farm?

Someone one once told be to “be wary of salesmen” and then I worked briefly with salesmen; be wary of salesmen.  It’s not because he’s trying to screw you ( he might be), it’s because there is a good chance he doesn’t know what he’s talking about, and there’s a better chance that his interests aren’t aligned with yours.  Equally, be wary of middlemen (the Madoff money-men) – they are salesmen too.  Suspect people who don’t invest their own money.  What does that even mean anyway?? It likely means that they only risk the money of others (risk nothing), and ‘eat’ no matter what.  You don’t necessarily have to be wary of the ‘free lunch,’ but of the person eating it – what did he/she do to deserve eating what you paid for, for free?.

Most CEO’s know next to nothing about the risks their companies face.  Coaches don’t know what their players are up to.  Markets, at any given moment, are inefficient.  That’s right, I said it.  Over time, or on average, markets are efficient [or close to it].  As Warren Buffet says, over the short-term the market is a ‘popularity contest.’  The world reacts, and mis-reacts, to information in knee-jerk fashion.   Point being – the world is not what it seems, mob mentality prevails, we are prone to fads and we usually over-react

We tend to define risk as something tangible that can be understood, categorized, and measured.  That may be kind of true, sometimes.  To me, risk has is what I might not be able to quantify (e.g. the likelihood that something that hasn’t happened [or is very rare] might happen).  Why do I speak of risk when questioning how much to pay for the farm?  Because if I don’t know the farm sits on a fault line I’m likely to overpay for it.  If I don’t know that the farm sits on oil reserves, I’m likely to sell it for less than I should have.  Missing a crack in the foundation is not likely to cost me near as much as either of the preceding two oversights.  The past decade has taught us that markets can stay inefficient for sustained periods of time (see real estate prices 2004-2007 in particular), and that longer the condition exists the greater the inevitable effects seem to be.  The point is that overlooking something that is entirely unlikely can, in our world, have exponentially greater ramifications that overlooking the more ‘obvious’ risk [the fault line vs. the foundation crack].

The lesson should be a different approach to ‘risk management’ [or bet selection], with a focus on determining the scenario that bares the greatest ramifications – regardless of its’ likelihood.  The lesson is not to avoid risk.  The lesson is to focus on what we don’t know, not what we know – it seems very seldom that people are surprised by the obvious risk, and more often that lives are affected by something that ‘could never have been expected.’

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