Risk Reward mispricing

Principles of Risk

In previous article on Risk and Probability, I’ve defined ‘risk’ as the possibility of total and irrecoverable loss. While some loss events are transitory, others are more permanent. Risk for an entrepreneur refers to the occurrence of total & permanent loss that he/she cannot recover from. In this episode, let’s dig deeper and understand the various principles underlying this concept of ‘risk’. 

Understanding risk is one of the most important asset for every entrepreneur. Risk levels keep changing with time & pricing risk proportionate to the reward/milestone makes decisions more consistent over time. Here are some important and universal principles of risk that I’ve discovered in my journey as an entrepreneur.

1. Outcome alone says nothing about the risk

Interpreting a quality of a decision by the result is referred to as ‘outcome bias’. Take an extreme example of a Ponzi Scheme – scheme gives tremendous returns to first few investors and that attracts more investors. Person running the Ponzi Scheme is providing great returns to his investors by recycling money from new investors to give outstanding returns to old investors. He runs the scheme for a few months, collects a sizeable chunk of money and then vanishes in thin air. All the later stage investors face a complete loss.

Appearance of great returns masks hidden risks. Even wise men get so overwhelmed by these returns that they don’t do the necessary due diligence. Returns alone do not tell us the underlying risks being accumulated by an entity. A good result does not mean good decision, a bad result does not mean poor decision. 

Good result may be an outcome of a poor decision. A bad result can be an outcome of a good decision

2. Result is observable, Risk is not.

Its very easy to understand risk in the current world of Covid19 – Let’s take an asymptomatic patient who has virus in his body. The fact that the virus has not manifested yet into a fever or cold or cough does not mean that the threat of virus is non existent. A symptom is actionable because it is observable but lack of a symptom does not mean lack of risk.

Absence of evidence is not evidence of abence

Nassim Taleb, Fooled by Randomness

If you go back to the risk-reward curve I introduced in article on Risk and Probability, I said lower end of the line is low risk, low reward. Higher end is the high risk, high reward.

Under-pricing risk leads to accepting dangerous risks

When risk is not observable, we end up either under-pricing the risk or over-pricing the risk. When you under-price the risk, you think you are getting a high return at a relatively low level of risk. The hidden risk can come back to haunt us at a later date as shown in figure below

Over-pricing risk leads to ‘passing up’ on great opportunities

Or we end up overpricing the risk and hence perceive that its a low-return opportunity and let it go. By not pricing risk accurately, we either end up exposing ourselves to too much risk or we pass on good opportunities.

Risk is challenging to observe not only because it is difficult to measure in future but is equally challenging to measure in the past. 

3. World measures ‘outcomes’ because it is easy & efficient

In 2009, Captain Sully landed a US airways flight 1549 in Hudson river and miraculously, all 155 people onboard survived. It was followed by a movie in which Tom Hanks played Captain Sully. Most papers and the world simply spoke about the leadership, courage & quick thinking of Captain Sully. I’m sure most of the world would brand Sully as an irresponsible, dangerous pilot and investigated his flying credentials, had 1549 blown up or killed passengers onboard. 

World wants quick decisions – measurable outcomes help us quickly brand something or someone as a ‘success’ or ‘failure’. While this might sound unfair, it is efficient because it saves time for everyone. Downside of such decision making is that it exposes us to the biases & traps of decision making.

So next time you reach out to an investor, a customer, or an employee – don’t worry if you are branded a failure or don’t be elated if you are branded a success – most likely they themselves are a victim of fast decision making that gives a large weight to outcomes and low weight to process

Everyone is a victim of decision biases created due to ‘outcome’ based decision making.

4. Luck or randomness is always hiding behind the result

Randomness is the invisible agent that influences result. It is extremely tough to separate out the effect of randomness from the outcome.

If you are an Avengers fan, you will appreciate ‘randomness’ in the scene where a rat accidentally brings back Ant man from quantum realm. Had Ant-man not come back, Avengers could not have saved the world from Thanos.

 In the last 5 years, we have seen some completely random events changing future of businesses and life forever. A lot of tech companies have hit gold while a lot of travel, food and hospitality businesses, even after taking a lot of right decisions, have gone bankrupt.

Separating this randomness from result & judging the decision purely based on underlying process is an extremely challenging task. In the next article, I will discuss how an entrepreneur can objectively measure and manage risk in daily lives.