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July 2008
August 2008

2008-07-04 »

Risk vs. Calculated Risk

It's accepted knowledge that potential returns in business are greater if you're willing to take on more risk. That is, a "safe" investment with guaranteed payoff will generally offer less than an "unsafe" investment that might fail. And so, if you have lots of money, as the wisdom goes, you might want to invest it in a wide variety of risky investments in order to collect some of that potential gain. The idea is that even if some of the risky investments fail, the increased profits from the non-failing ones should more than pay for the loss.

Okay, so far so good, but the problem with risk is that it's random. And worse, there are a lot more worthless risky investments than valuable ones; such is the state of humanity. (In contrast, "safe" investments, by definition, don't really have that problem.)

Enter the concept of a "calculated risk." The idea here is that if you're careful, you'll be able to see which risky investments are better, and thus collect on the returns instead of losing all your money.

But there's a problem with that theory. The problem is that if everyone could just figure out what's a "good risk" vs. a "bad risk," then everyone would want to invest in the same things. Thanks to supply and demand, this basically sucks the profit out of such obvious investments. Various problems with fancy hedge funds and the recent subprime crisis can all be traced to this problem: everyone agreed that a particular risk was "good" at the same time, and over-invested in it until the profit was gone.

But wait! If supply and demand can suck the life out of risky invements, what makes risk such a great thing, again?

My entrepreneurship professor in university used to say that a better term for calculated risk would be "risky calculation," because that puts more emphasis on calculation than on risk. And the more I learn about business, the more I realize how absolutely right that is. Profits don't come from risk. Of course they don't! Who wants to buy pure risk, except compulsive gamblers? Profits actually stem from the quality of the investment, and you can buy into an investment at a good price only when other people don't. Perceived risk is just one possible reason that people might avoid a particular high-quality investment.

I don't have huge boatloads of money, so I don't usually think about investing from the point of view of investing money. I think more about where to invest my time, because my time is the most valuable thing I have. Right now, the cool thing for a programmer like me to do is to form a web startup. But I'm not doing that, because the space is risky and overinvested. It's completely wrong on both axes. If you want to be successful in the market right now, do something safe and underserved.

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