Smart Risks

One misconception I got from the academic theory of finance is that risk and reward go together. You take on more risk, you get more reward. This is formalised in CAPM theory as a higher expected return associated with a higher standard deviation of investment returns.

In reality, ∃ many stupid risks—mistakes, bad ideas, not doing your homework, believing people you shouldn’t believe, taking on a job without negotiating a floor for your own compensation first, or investing in a company that was bound to tank.

Recently, academics have undercut the premise that risk goes hand-in-hand with reward. Perhaps this pill is easier to swallow after seeing “dumb money in Düsseldorf” vacuum up synthetic CDO pyrite (AAA mortgage bonds) spun from BBB bonds—and then find out, publicly, along with the rest of investment Narnia, that the rewards were nowhere near commensurate with the risks.

I’ve seen this play out a little more in private equity, where models of price paths are less influential than common sense, gut reactions, and balance-sheet research.

I don’t know as much about trading. But I’ve read between the lines on the EliteTrader forum and its cousins, and got the sense that, as academic papers that study the matter report: most day-traders lose money on expectation. Their trading capital approaches $0 faster than would be expected merely by the drag of trading fees on a statistical mean of zero profit.

 

Warren Buffett, the world’s best living investor, is in a business where risk and reward are inverted from the CAPM model. (He’s written about it plenty so I won’t repeat him.)

Insurance and reinsurance companies, though they may serve a social function, aren’t actually concerned with actuarially converting risk into reward. They’re interested in collecting as many large premia as possible for risks that will never harm their balance sheet. Why do you think they have three times as many claims adjusters as actuaries? Si guarda al fine.

Michael Price, one of the stars of The Vulture Investors, bought a loan to a bankrupt company for 47¢ on the dollar, covered 15¢ immediately with cash, plus 45¢ in bonds plus 23% of the post-bankruptcy company. He needed the bargaining skills and the capital to buy out other bondholders and negotiate a good rate for 

One last classic example: McDonald’s. Ray Kroc saw a huge return on investment but only took smart risks, doing less of the hard work and spending more time being successful. Mr. Kroc didn’t finish college with a bright-eyed hope to be the world’s greatest entrepreneur (cf. YCombinator). He sold Dixie cups for 17 years before he saw an opportunity—in a B2B space—with high returns and low costs. (Selling malt mixing machines back when malts were the profit centre for burger joints—a malt might cost as much as sandwich + fries, or even as much as sandwich+fries+coffee.) The malt mixer business was a classic play; it would earn 100% checkmarks from a Business 101 textbook. Only after Ray Kroc saw another opportunity related to the business he was in, did he buy up the MacDonald Brothers’ restaurant and multiply it out. Again, this is a textbook private-equity move: find a proven business where somebody has completely figured out how to make money hand over fist, such that the only other thing they need is more money. (Obviously this is very different from an entrepreneur with an idea who just wants some money or thinks their failing idea would be saved if only they had more money.) You provide the money and collect the multiplied profits, i.e. you take on the easy part of the problem, negotiate the terms so you get a huge return on solving it, and then you’ve done little work for great reward. That’s a “smart risk”, not a correlation of risk and reward.

 

We could probably go back and forth with examples of titanic companies. (Sure, Ted Turner threw massive sums into a money pit for over a decade before seeing TNT and its siblings become profitable.)

But still I think the overall message of risk~reward is wrong. There are smart risks, and there are dumb risks. Don’t expect that just because you did something risky, that the return will be good. Work smart, not hard. Cover your *rse and check yourself before you wreck yourself.

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About isomorphismes

Argonaut: someone engaged in a dangerous but potentially rewarding adventure.
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