Investors and Entrepreneurs don’t really look for risk
Low risk and high uncertainty provide the best opportunities for high returns
There is a common perception of Investors and Entrepreneurs as strong risk-takers. Being exposed to high-stakes decisions under critical circumstances, they clearly need to develop an uncommon capacity to analyse risks and rewards.
However, this does not mean they necessarily have a strong risk appetite. For a broad group of practitioners, it is quite the contrary. After all, even the great investor Warren Buffett famously summarises his investing strategy with these two rules:
“Rule number one: never lose money. Rule number two: never forget rule number one”. This approach clearly presents a risk-averse approach to investing.
In his book – the Dandho Investor – world-renowned Investor and Buffett’s disciple – Mohnish Pabrai explained his risk-averse strategy with this statement: low risk and high uncertainty is the perfect combination for business ventures and investments. In his experience, entrepreneurs do everything they can to minimise risk. They are not interested in taking a risk for potential gains. They rather focus on low-risk bets which have high-return possibilities.
In Pabrai’s view, the true risk is the potential for capital loss, while uncertainty just entails a wide range of unknown outcomes. Stock markets have a perspective that businesses should have extreme predictability. Unfortunately, the business world doesn’t work like that; it’s messy. It has its ups and downs. While the market hates uncertainty, you don’t have to. When you have high uncertainty in a business venture, coupled with low-risk, the result is a situation where you should be willing to dig into potentials for high returns.
What does not kill you make you stronger
- Monish’s approach inevitably challenges the simplistic causal correlation between risks and returns. While public knowledge and industry alike rely on such assumption, in day to day life, returns are not necessarily correlated to the level of risk taken. This is where you find opportunities.
- His approach reminds me of the concept of asymmetric investing, a strategy that looks for opportunities that limit the downside risk (potential for loss or the magnitude of failure) while keeping an open upside potential.
- Monish goes beyond risk, introducing the concept of uncertainty. The difference between risk and uncertainty is not clear-cut, which is why he believes many investors and entrepreneurs fail to grasp and profit from it.
- The definitions of risk and uncertainty are the subject of studies in several disciplines and business fields. In general terms, the modern decision theory provides a clear explanation. It defines decision under risk, those situations where all potential outcomes and their likelihood of occurrences are known and therefore measurable. On the other hand, uncertainty refers to conditions under which the outcomes and/or their probabilities are unknown. This reminds me of US Secretary of State Donald Rumsfeld statement: “as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know”.
- In general, we can state that risk management is easier because you can identify and measure it. You can study the outcomes and its probabilities. With risk management analysis you can make sure to limit the risk of capital loss. On the other hand, managing uncertainty is difficult, as full information is not available, too many parameters are involved, and you cannot ultimately predict the outcome. However, what you can do is to cap the downside risk, and open up to upside outcomes of uncertainty.
To a certain extent, what does not kill you, make you stronger: once you know that the investment decision does not harm you with capital loss, you are open to untapped business and investment opportunities. This is not necessarily a riskier approach, but it entails lower visibility and uncertainty of the outcomes.
Until next time, Sweat Your Assets.