ANOTHER LOOK AT RISK vs. REWARD: Quantifying Risk

It’s a sure thing, it can’t miss! We’ve all heard it before. We’ve also heard “but no one could have predicted…” and “the odds were a thousand to one that…” afterwards. Words spoken by smart people who were making good decisions based on odds that were strongly in their favor. With that in mind, let’s take closer look at Risk vs Reward.

PROJECTIONS

It is a given that you cannot have Reward without Risk. The conventional wisdom is that when evaluating the Risk/Reward of a prospective (ie real estate) investment, you calculate the potential dollars of Reward for every dollar at Risk. You do this by analyzing myriad potential investment outcomes and the likelihood – the odds – of each one coming to pass. It usually requires contemplating of a wide array of fluctuating variables, which makes it difficult to accomplish with precision, even within a liberal coefficient of variation (margin of error).

Imperfections notwithstanding, with strategic thinking and sound modelling tools, we can make reasonable and often quite accurate projections – provided that we use objective, relevant variables and reliable economic indicators.  Creating projections is making use of experience – the past, to presuppose likely outcomes – the future.  That said, the future is stubbornly elusive and fickle. Financial offerings contain that ubiquitous phrase “past performance is no guarantee of future results” for good reason. Moreover, the further into the future we try to forecast, the less reliable our projections are destined to be. To illustrate the point, if SpaceX were sending a spaceship from the earth to the moon and its guidance was off by just 1 one-hundredth of 1 inch after 1 foot (the near future), it would miss the moon (the distant future) by a distance wider than the state of Michigan. Fortunately, in real estate investing, as with the ship headed for the moon, we often have time to course-correct – influence the direction of an investment – but that’s a topic we’ll discuss in the future.

THE GREAT UNKNOWNS

When I analyze an investment for a client, the templates I use employ use as wide an array of variables as I believe to be practical for the given asset, which can be copious in some cases. In the end, I feel pretty good that I have a clear picture of the opportunities and threats. I’ll run multiple scenarios to identify best- and worst-case scenarios. Most importantly, the worst-case scenarios seek to contemplate “future unknowns,” which is redundant, because the future doesn’t exist yet and by definition is unknown. As former Secretary of Defense Donald Rumsfeld famously obfuscated “…there are ‘known knowns’; these 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 …it’s the latter category that tend to be the difficult ones.” Well that certainly covers everything!

Even that enigmatic quote misses the point that the future is more than unknown – it is unknowable, and yet, business requires that we make projections. Coronavirus puts in stark relief just how much “future unknowns” are something to be reckoned with. They can be estimated and projected (all euphemisms for “guessed”), but ultimately, they are not knowable. Meanwhile, my clients don’t want to hear “…but no one could have predicted…” so I must contemplate both the knowns and the unknowns and advise accordingly.

CAN YOU HANDLE IT?

OK, but then isn’t “planning for the unknown” a contradiction in terms; and what the hell does this all have to do with Risk vs Reward?  As stated earlier, the prevailing interpretation emphasizes probability: comparing the cost with the potential income; if and when you are comfortable with that ratio, you move forward with an investment. The problem with this reasoning is that it conflates risk with ROI, which it is not.

I see risk differently: Risk vs Reward should be governed by the rule that “when the unknown becomes known and it ain’t good, when that “can’t-miss” misses, can you handle it?”  This relegates probability to a subordinate position; meaning threat is the primary focus. This is because if the “miss” is catastrophic, whatever the odds were and whatever the reward might have otherwise been, it’s game-over.  So while it is true that you can’t predict the unknown, you must be plan for it.

THEORY OF RELATIVITY

From this point of view we recognize that a “good investment” is relative, it is not absolute. For example, I might not risk $100,000 on a given investment for which Amazon founder Jeff Bezos would comfortably risk $1,000,000; simply because losing a million dollars is a rounding error for him, whereas losing a hundred thousand dollars would be impactful to me.

Same investment, different risk.

This is a key part of the axiom that “money makes money”: statistically, “safe bets” will in fact prevail across multiple events; however, you need the opportunity to engage in multiple events. Think of the Hundred-year flood, where the potential of a flooding is very low statistical threat; unless, however, if that one-year is this year, and you just bought a property and saved money on flood insurance.  Las Vegas casinos are a ten-billion-dollar industry built on millions of relatively small transactions, winners beating losers over time, based on the thinnest of margins. Properly managing risk means staying at the table and prepared for the hands where reward is most likely.

“Odds are” you have a different take on the subject. I’d be glad to hear what you think as well.