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Risk the Mother of All Bad Deals

Our second principle at Richucation is rich people love great deals, they love to be able to buy things for less than those things are worth.  There are many factors in this process such as knowing your true costs (a good friend once remarked it’s worth it to pay $200 for a shirt you like because the real cost isn’t the shirt, it’s your time to find one that’s perfect for you and you’ll spend more money in time trying to find a better deal or find another you love for a great price than you will save), knowing the accurate value of what you’re buying, etc. but ultimately we return to this as a foundational principle and our first lesson to new students.  Rarely accounted for though is the cost of risk and how risk undermines good deals.

Mark Cuban, the billionaire owner of the Dallas Mavericks, once remarked on his blog that the score comes not from what you extract from any single deal but what you end up with overall.  Put another way it doesn’t matter how an athlete performs in a single game, it is their average over time, the aggregate results.  Most successful companies lose money on various transactions throughout the year but in the aggregate those transactions are covered off by the profitable ones.  The key is knowing those numbers to ensure the winners more than cover the losers and then improving the statistics.

Nowhere is this more true or the dangers more insidious than when considering risk.

Risk is not a particularly popular word with entrepreneurs, by nature entrepreneurs tend to be optimistic, they also tend to as a group overlook failures and focus on successes and psychologically this approach has merit.  In terms of creating success you’ve got to look at the failures and the failure rates.

Let’s start by defining risk.  In this case risk is the probability of failure and its related cost.  It is most insidious because you don’t see it in the short term, it only shows up in the long term so you can have what appear to be great successes that ultimately turn out to be great failures.

Consider the example of the exempt market investment products industry.  Walk into in local investment office and ask them about their available products and they’ll tell you all about the MICs, the real estate development LPs, and many more.  They’ll frequently pitch returns ranging from 8% to 25% per year.  Consider yourself warned, Warren Buffett averages 20%/yr. over a long period, if you think these guys can get you a 25%/yr. return in the aggregate (meaning not by getting lucky during a small cross section of the cycle but when averaged across the whole cycle and repeated cycles) you’re probably deceiving yourself.  Are 25+% returns possible?  Yes, definitely, especially in small deals in limited timeframes by very skillful experts.  Buffett has actually remarked that he could get 50% on $1 million because the dynamics are different.  However, keep in mind that in order to return you 25% the company really needs to be earning probably 35% – 40% because they have to pay all their expenses plus etch out a profit.  Let me be clear, no one truly offers consistent long term returns of 25+%.  The only people who get that are people who are managing their own money often in their own business and other factors weigh in, you should probably be running from promises such as those.  But what about the lower end, a 10% return.  This is very respectable and certainly attainable so you can accept those numbers right?  Not really.  Those in the exempt market industry are fond of harping against the mainstream investment industry pushing mutual funds and GICs.  They talk of beating the market through the exempt market but the truth isn’t nearly so glamorous because the general market accounts for risk in its figures the exempt market does not.

When your mutual fund advisor tells you about the 5%/yr. returns a particular fund has averaged over the last 20 years that’s after accounting for all the ups and downs of those decades.  It might have been 15% one year and -15% another year but after all was said and done they managed to scrape together a 5%/yr. return.  When your exempt market dealer tells you about the 8%/yr. you’ll be getting that’s not an aggregate of results, that’s a promise made without security.  In other words there probably are some that will pay 8%/yr. just like a couple stocks in that bundle within the mutual fund will actually earn a 15%/yr. return.  The problem is people, including investment advisors and portfolio managers, are notoriously bad at picking those companies so to protect you from the risk they buy dozens and work the averages.  You can do the same thing within the exempt market but you’ve got to realize that’s how you’ll see your real returns and it won’t be pretty.  Of those 8%/yr. companies you might actually have a couple that lose all your money, a couple where you lose 20% of your money, a couple might actually pay 5%/yr. and a couple might even pay the full 8%/yr.  The problem is for you to pick, for your investment advisor to pick, for you to be able to bank on it is extremely unlikely.  Thus, you have to when you’re making your investments look at the probability of failure and account for those probabilities.

A simple example, if you’ve got a 20% projected rate of return with a 20% chance of complete loss (btw the chances of complete loss in the exempt market are very high, there’s rarely any cases where investors recoup only a portion of their money, they tend to get returns or lose it all) then what’s your real rate of return?  The real rate of return in the aggregate is actually 0%, meaning if you invest several times these will average out to a 0% rate of return.  You might get lucky and hit a winner without a loser; then again you might get unlucky and hit some losers without any winners (they tend to clump together because they tend to be based on the current stage of the market cycle).  Bottom line you need to be able to do the numbers and make decisions based on the probabilities not based on the projections or promises of advisors and sales people.

The same principle applies in business since all business is an investment.  A real example, I had a company where we’d run promotions with heavy advertising and at the end of the promotion period we’d calculate how we did when accounting for all the advertising expenses, cost of goods sold, wages, commissions, merchant processing, etc.  We’d look at the numbers, see we were pulling in a healthy profit and act accordingly run regular promotions to get the volume high enough to surpass breakeven.    At first, all looked good but there was a critical error in the calculations…the defect rate.  Not that often, but often enough we’d have a defective product that would need to be replaced.  When I’d become involved in the company I’d added warranty upsells so that helped to cover some of the cost and at first blush we’d figured it was no big deal because our margins were so strong, about 75% gross margins we had plenty of room to replace a few defective products and the high level of customer service we offered was good for business.

What was the problem?  First, we didn’t know the defect rates or account for them conservatively in our numbers so we’d walk away from a weekend seeing a $12 000 profit and in the short term that was true, in the long term it was not.  It got worse though, when we looked at the costs we were thinking in terms of a 25% cost, if we say had a 25% defect rate at a 25% cost we just needed to add an additional 6.25% to each product sold to account for these losses.  But what of the real costs?  We needed to pay staff to take the phone calls, to handle customer RMA requests.  We needed to pay for return shipping of the defective unit as well as shipping to the client of the replacement unit often times those shipping costs could exceed our cost on the product to begin with.  Even all those might have been tolerable but in many cases we were selling through a third party and we were hit with refunds.  Now in the case of refunds we needed to refund their full money, but we’d still incurred the shipping costs, we still incurred the staff costs to handle it all, and we now had an opened or defective unit we couldn’t easily resell.  In such cases it was a pure loss that needed to be accounted for.

The bottom line is these sorts of considerations exist in any business and you need to count the aggregate, the long term and the large numbers, not any one instance or sale and you need to turn that into a profit or the business model isn’t sustainable and scalable.

For assistance with figuring this out and developing strategies to mitigate this risk or any other business, investing, and wealth building questions please contact us by clicking “Ask a Business Question” in the lower right corner of the screen and we’ll be happy to assist you.