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A New Way to Measure Risk

“If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubts, he shall end in certainty.” - Francis Bacon

“Markets operate under uncertainty. It is therefore crucial to market performance that participants manage their risks properly… To the extent that policymakers are unable to anticipate or evaluate the types of complex risks that the newer financial technologies are producing, the answer, as it has always been… less debt, more equity, and hence a larger buffer against adversity.” - Alan Greenspan

The first time I sat down with a financial planner, I was asked what my risk tolerance was – risk adverse, moderate risk taker or aggressive. At 22 years of age and having no idea how to measure risk, aggressive sounded good to me. This caused my financial planner to suggest investments I certainly wasn’t ready for since I had no idea of how to manage them properly. In the short term, I made lots of money, but needless to say, I ultimately lost all the profits because I didn’t know when to get out.

Oftentimes, we calculate risk based upon the probability of success or failure of a business venture or investment. In most cases, if the odds are heavily in our favor to succeed, it is deemed less risky and a good investment or business opportunity. However, I want to illustrate to you through a real situation with people far more experienced than you and I in the business world that using that model is no longer good enough.

Long Term Capital Management was a hedge fund founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. The board of directors included an all star cast of Wall Street veterans including Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economics. The hedge fund involved itself in very complex investing called arbitrage or the practice of taking advantage of a price difference between two or more markets striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.

To assess the risk of their investment portfolio, they used some of the same basic principles that most individual investors are encouraged to use today. They used tools such as expected returns, standard deviations, and correlation coefficients. Based on these metrics, their portfolio was triple A rock solid. According to their own marketing, the risk of a 10% annual loss in their portfolio was about 1 in 1,000 years. The risk of a 50% loss was approximately 1 in 10,000,000,000,000,000,000,000,000,000,000 years, or several billion times the age of our universe.

Initially enormously successful with annualized returns of over 40% (after fees) in its first years, on August 21, 1998, Long Term Capital Management lost in a single day $550 million. In total it lost $4.6 billion in less than four months following the Russian financial crisis.

The risk models on which LTCM based their analysis were developed on assumptions that the market would always respond the way it did in the past. They did not factor the potential of a drastic occurrence in the market like Russia defaulting on its bond payments because it had never occurred before. However, knowing that Russia had faced continued financial crisis throughout the 1990s, Russia was certainly capable of defaulting.

In such a fast paced market, it is easy to forgo the proper steps to minimize risk. However, failure to do so is a recipe for disaster. The risk you face is inversely proportional to the relevant preparation you do. Thorough due diligence is critical. You must know, not guess, what risks you face, the possible outcomes if they come to fruition and how to offset those risks before you take action. Create contingencies in advance of problems.

It is important in reducing risk that you constantly analyze and reevaluate all deals that you are currently in. Analyze the numbers meticulously. Once it is determined that a deal is no longer profitable, do what is necessary to get out of that deal as fast as possible. You can’t make a bad deal good.

Risk Assessment

The first method for minimizing risk is to become market-centric. If you are considering opening a business, only provide what your target market wants and it significantly reduces the risk of failure. If you are considering investing, the cardinal rule is you should never invest in anything you don’t understand.

Before fully committing to any deal, business or investment, make sure you do the math. The numbers don’t lie. You will have a good idea of potential profit just by analyzing the numbers properly. If the numbers appear profitable, go to the next step which is to write a detailed business plan.

Even with a well written business plan, it is important to test your plan on a small target market or a small investment first. In business, it’s a small offering to a select target market before going forward with a full production run. In real estate it could be doing a lease with an option to buy instead of a traditional purchase. In stock investing it could be purchasing options instead of the actual stock. The rule is test small lose small, test big lose big. If the test proves your plan to be effective, only then should you fully rollout the plan.

Do your due diligence on anybody you plan to do business with. If you discover that the person or company you want to do business with has questionable business dealings with others do not do business with them. You can’t do good deals with bad people. You will not outsmart them and they will not treat you different than any body else. Bad people eventually get everybody they do business with.

Check local and federal regulations to ensure that the venture you get into isn’t so heavily regulated that it becomes too difficult or too costly to be profitable.

After thoroughly, researching, planning and testing ask yourself this key question: “Can I live with the consequences if this doesn’t work?” If the answer is no, it does not matter how good the odds seem of success, if you cannot handle the outcome of the deal if it fails, then let that opportunity pass.