We All Need a Risk Framework

I recently read “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor” by Howard Marks, Chairman and cofounder of Oaktree Capital Management. While I’m not an investor, Juan Serrate (@JPZaragoza1) brought the book to my attention during a Twittersation about risk. In my job developing a discovery into an actual drug, I think a lot about finding investors (strategic and/or financial), value and risk. Marks covers all of these topics but for this post I chose the parts that resonated with me from a business building perspective. As in investing, entrepreneurship is a (seemingly never ending) series of risk evaluation and mitigation. (For discussions of risk with drug development examples, read Michael Gilman’s (@Michael_Gilman) posts The Awesome Power of Risk and Risk: A User’s Guide For Drug Developers.)

Marks’ Three Steps of Risk

Marks provides three chapters on dealing with risk in investing, each with a specific focus.

The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it.

Probability Distributions and Risk

This graph should be on the cover of this (or another) book. The relationship between risk and reward (sort of like return) is often discussed as though it is linear – more of one leads to more of the other. But in this straightforward visual, Marks demonstrates the fallacy of that idea. (One could quibble about the use of normal distribution for the curves but the takeaway is still important.)

ReturnRiskGraph Marks Annotated

What is Risk?

Our next major task is to define risk. What exactly does it involve? We can get an idea from its synonyms: danger, hazard, jeopardy, peril. They all sound like reasonable candidates, and pretty undesirable. And yet, finance theory…defines risk very precisely as volatility (or variability or deviation). None of these conveys the necessary sense of “peril.”

This paragraph really resonated for me personally. The finance definition has no emotional connation – there is volatility in being a new parent as well as in losing a loved one. This definition is more meaningful once Marks adds to the equation (see below: Risk + Adversity = Loss).

Kinds of Risk

There are two kinds of risk conversations I tend to have with other entrepreneurs. One uses adjectives such as inherent and acceptable to describe action related to the risk. The second is more common in biotech/pharma and revolves around separating risk into two buckets: business vs. technical. Marks moves beyond the more concrete areas and enumerates a number of psychological risks in investing, including:

  • Falling short of one’s goal
  • Underperformance
  • Career risk
  • Unconventionality
  • Illiquidity

While the risks taken are different for investors and entrepreneurs, these categories are spot on in my experience as and with entrepreneurs.

Measuring Risk

An important question remains: how do they measure that risk? First, it clearly is nothing but a matter of opinion: hopefully an educated, skillful estimate of the future, but still just an estimate. Second, the standard for quantification is nonexistent…. Third, risk is deceptive.

Marks’ second step – recognizing when risk is high – can only be accomplished if you have a framework for comparison, which requires measurement. Not only is “accepting risk a personal matter” but measuring it is also “a matter of opinion”. Bring together technical and business experts not only identify different risks but each group sees different levels of risk in the other areas. In my experience, greater risk is generally seen in the other person’s activities.

Risk Management is an Unheralded Skillset

Since it’s hard to gauge risk and risk-adjusted performance (even after the fact), and since the importance of managing risk is widely underappreciated, investors rarely gain recognition for having done a great job in this regard. That’s especially true in good times.

I believe entrepreneurs (and management) have the same recognition issue, and this idea ties back into the psychological risks noted above, such as underperformance.

Because Risk is Invisible

Why isn’t risk management celebrated? I’m glad you asked.

risk is covert, invisible. Risk— the possibility of loss —is not observable. What is observable is loss, and loss generally happens only when risk collides with negative events.

 

This is a very important point, so let me give you a couple of analogies to make sure it’s clear. Germs cause illness, but germs themselves are not illness. We might say illness is what results when germs take hold. Homes in California may or may not have construction flaws that would make them collapse during earthquakes. We find out only when earthquakes occur.

Risk + Adversity = Loss

Likewise, loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment.

Coming back to the definition of risk, the variability (possibility for multiple outcomes) in itself is not sufficient to cause loss.

Avoiding Loss

Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.

Here is the crux of the entrepreneurial experience. Building a business requires one to take risks, but risk control can be challenging when you are close to a situation. (Here is some insight from Kahneman about entrepreneurs (here & here) and executives exhibiting more optimism than warranted.)

Biggest Risk = Believing There is No Risk

There are few things as risky as the widespread belief that there’s no risk.

Pstscript: Worry, Skepticism and Pessimism

There were chapters on how to be a better investor and I picked a couple of highlights that apply to entrepreneurship:

Worry and its relatives, distrust, skepticism and risk aversion, are essential ingredients in a safe financial system.

Who wants to be around a distrustful, skeptical worrywart?!? But as I thought about these attributes, they are part of my job description…imaging what might go wrong so we can take actions to avoid those outcomes. From a personal perspective, working to focus these behaviors on specific areas rather than having them as default across the board is very important.

that triggered an epiphany: skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.

In simpler terms, don’t just follow the herd. Or as Bruce Booth (@lifescivc) wrote about cancer drug targets, avoid lemming behavior.

Worry about the possibility of loss. Worry that there’s something you don’t know. Worry that you can make high-quality decisions but still be hit by bad luck or surprise events. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong. And if nothing does go wrong, surely the winners will take care of themselves.

 

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Trackbacks/Pingbacks

  1. #MHVF Approaches to Drug Development | The Next Element - March 10, 2015

    […] mean to say that on stage but there it is. I recently wrote another post that applies here: We All Need a Risk Framework, which is based on a book by Howard Marks, Chairman and cofounder of Oaktree Capital Management. […]

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