Here’s the easy part: risk is everywhere – even a decision to not take any risks is risky.  Now the hard part: how to make risk work for you and your business.

Risk vs. Reward

People often say “The higher the risk, the higher the reward,” as if a higher risk automatically comes with a higher reward.  Not so.  The true way to look at it is: the higher the risk, the higher the potential reward must be in order to justify the risk.  This means that you need to quantify the risk and quantify the potential reward if you’re going to have a chance to make a good assessment of the risk.

How about an example? Let’s say you’re presented with the following: invest $1MM in a new product that could return $10MM? Is it a good risk? At first blush, sure!  Of course if the only potential buyer of the product is the Thai government and the downside is that your entire investment will be lost if they don’t purchase, you might be more inclined to pass on this.

Probability Theory

Probability theory, particularly the concept of expected return, can help here.  Expected return calculates what you can expect to wind up with if the situation were encountered a large number of times.  Obviously, this isn’t how risk is often experienced in the real world, but it does allow for a direct comparison of large results and wide-ranging probabilities. It’s a simple calculation: probability * result.   Our risky investment example it might look something like:

• Investment cost of product: $1,000,000
• Odds that  the investment cost will be incurred: 100%
• Return if product is a success: $10,000,000
• Odds that the Thai government will purchase the product:  1%
• This leads to an expected return of: – $1,000,000*100% + $10,000,000*1% = -$900,000.

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A poor risk indeed.

Risk Mitigation

Is that it?  Time to move on to the next idea?  What if we try to mitigate the risk by doing some up-front work and exploration before committing to the full investment?  Build a proof-of-concept model and travel to Thailand for a quick dog-and-pony show with the buyer.  Let’s assume that we’ll only go forward with development if the Thai government expresses strong interest in the product (5% chance).  If the government expresses strong interest, we estimate the odds that they will purchase the full product are 20%.  This means that the 95% of the time the project will be canceled before any additional money is spent and that the overall purchase percentage remains 1%.  Our newly-mitigated risky investment might look something like:

• Exploratory investment: $50,000
• Odds that the exploratory investment will be made: 100%
• Full development investment: $1,000,000
• Odds that the Thai government will express strong interest and that the full development investment will be made: 5%
• Return if product is a success: $10,000,000
• Odds that the Thai government will purchase the product if they express strong interest:  20%
• This leads to an expected return of: -$50,000*100% – $1,000,000*5% + $10,000,000*20% = $1,918,000.

Now that’s a much better risk.

Strategic Risk Management

Should you take it?  In a vacuum, yes.  A better answer would be to compare the expected return for this investment option with the expected return of competing investment options and pick the best one.  An even better answer might be to strategically manage risk by budgeting exploratory investments for a few options, and then fully fund the option that comes out looking the best.  This gives your company the best of many worlds: rather than being forced to pick a winner before any work is done, a set of low-risk, low-cost efforts could lead to a reduced risk, high return investment decision.

Venture capital and private equity firms manage risk in a similar way: they invest a small amount in a number of companies expecting:

• Some will fail completely.
• Some will have promising initial results and require additional investment.  Of these:
  • Some will only break even on their investment.
  • A couple will deliver 2x return on their investment.
  • One (hopefully) will deliver 10x return on investment.

If all goes as planned, this set of results can lead to an overall investment return of 100% or more.  Or less, of course.  The more or less being largely dependent on the risk mitigation efforts undertaken by the investors.

If you have any questions about this article or want to talk about how to use risk as a competitive advantage, contact me at  617-855-5439 or jmarcos@complexityclarified.com.