I have been doing a lot of thinking about risk, reward, and probability and how these things affect our decision making processes. I often wonder if there is a direct and proportionate correlation between risk and reward and how much probability has an impact on the risk/reward relationship.
Risk has many different variations and is usually defined as something that “could” occur. Probability is the statistical likelihood of an event occurring. Risk, as the word implies, has a negative impact. Whereas, probability has neither a positive or negative impact; it is simply a value. I think it is important to understand the relationship between risk and probability especially when we’re making decisions that can have either physical or economic consequences. My curiosity on the topic stems from working with startup companies and the thought process that goes into which companies should we invest into or not.
The old adage goes “that with more risk the higher potential reward.” What I think is missing from this statement is that at a certain level of risk there is no increase in reward, and with any further increase in risk the incremental increase in reward becomes insignificant. For example, investment portfolio construction is a great example of where this concept is most prevalent. Investing, say $1M equally across your five startup companies will most likely yield the same result as investing the same amount of money equally into 10 startups. The reason behind this is simple – probability. For startups, the probability that they either fail or become the walking dead is a combined 80%. Meaning, there is only a 20% probability that any startup will become wildly successful. Therefore, with a portfolio of five companies, 1 might succeed, and with a portfolio of 10 companies, 2 might succeed. In the world of early stage investing these statistics are widely accepted and are commonly used a starting point for optimizing the potential return for this type of investing.
Is it more appropriate to consider risk/probability instead of risk/reward? Understanding how to assess and evaluate probable outcomes is a skill that comes with experience and is often times easier when done collectively in groups. For example, I once participated in a risk exercise with a company’s management and board of directors where we were trying to weigh the risk of selling the company now for a certain price, or waiting a few years longer to possibly sell the company for a higher price. The exercise started with each person writing down how much they thought the company might sell for in 1 year, 3 years, 5 years, and 7 years. Then we each assigned a percentage to each price for each year. For example, in 1 year from today the company might sell for $25M and there was a 50% chance that that might happen; Year 3, $35M, 25%; Year 5, $50M, 10%; and Year 7, $75M, 15%. The sum of the probabilities must add to 100%. Each person privately wrote down their estimates and when we were all done we recorded our answers into a spreadsheet and took an average of all the responses. Even with a few high and low outliers, the overall combined desired sale price for the group was only 5.5% higher than the offer that was on the table. The good news is, the company did eventually sell for close to the price everyone wanted and this risk vs probability exercise was one form of qualitative analysis the company used to justify the sell decision.
In summary, the risk/reward conversation can be made much more interesting when you consider probability as well. For every risk, there is a downside and an upside. And for every risk, there is an associated probability of it actually happening. Low-risk, low-probability events can often be ignored. However, when you’re making long-term, high dollar investment decisions into a company as either an investor or an entrepreneur, I think it’s prudent to consider risk, reward, and probability together in your decision making. Lastly, this was a fun but difficult blog post to write because risk/reward/probably can be a very complicated subject and I purposefully left a lot out. I’d love to hear from some of you your thoughts on this topic because I find it very interesting!