What We Talk About When We Talk About Risk
Risk management, not risk elimination. There’s no return without risk, so eliminating risk means you’ve eliminated upside exposure. When most people talk about risk management, they’re referring to investments or insurance. Managing risk exposure in these areas is important but not sufficient. The startup ecosystem introduces unique risks that must be considered, and this is what we talk about when we talk about risk.
Rules of Risk Management
- Don’t die.
- Risk should be taken in pursuit of the resources needed to fund your desired life.
- While pursuing resources, remember to not die.
Don’t die refers to go-to-zero risk. It’s the stock that goes to zero, it’s burnout, it’s restarting from scratch. It’s also a cessation of compounding. By plotting your desired life across time, you can identify the types and amounts of resources necessary to achieve it. Some of those resources will be financial, others will be components of your human capital (skills, relationships, and ability to co-create). At any point along the way, compounding will help bridge the gap between what you have and what you will need. In order to experience this compounding, you’ll need to take some risks. Resources will need to be invested, career choices will need to be courageous. Taking insufficient risk is a surefire path to insufficient return, but taking unnecessary risk introduces uncertainty and fragility. The key lies in finding the appropriate amount of risk that plots a path towards your desired outcome. But that’s not possible without accounting for your “starting position”, as two people with different starting positions will have different amounts of necessary risk to reach their goals.
(i) Low risk, low return, starting from zero. No outcomes where goal is reached. By not taking enough risk, you create certainty that you can't have your desired lived experience.
(ii) Low risk, low return, higher starting position. "Expected return" achieves your goal, but there's still downside risk. Requires monitoring over time to ensure you are on track.
(iii) High risk, high return, starting from zero. Higher chance goal is reached, but also higher chance of go-to-zero.
(iv) High risk, high return, higher starting position. Goal is exceeded in most scenarios, but downside risk is significant.
Once you account for starting position and desired ending position you can identify how much risk you need to take on to reach your goals. Next, work to balance exposure to blow up risk inherent in seeking higher returns against the prospect of earning insufficient return by playing it safer than needed. Striking the right balance for you requires considering the levels of risk for an individual.
The Three Levels of Risk.
- Risk you can take due to your risk capacity.
- Risk you feel comfortable taking due to your risk tolerance.
- Risk you need to take to have a chance to reach your desired outcomes.
Ideally your risk capacity (1) exceeds both your risk tolerance (2) and your necessary risk (3). If it doesn’t you’ll need to change your resources, goals, or sentiments in order to align the three correctly.
Influencing Your Risk Profile
Risk tolerance is mostly innate, but is also influenced by the people around you. If you surround yourself with risk takers, your own risk tolerance is likely to increase. If you surround yourself with timidity, you are less likely to take big risks.
Risk necessity depends on the gap between your goals and your starting position. A liquidity event, inheritance, or other windfall would shift your position and therefore change how much risk you need to take.
Risk capacity is the easiest component to influence because it consists of things you can control. You can increase your risk capacity by increasing resources or by eliminating downside risks. Specifically, you can aim to reduce exposure to risks that don't offer asymmetric upside. Startup equity and a lack of life insurance both have blowup risk. But startup equity offers potential return, while forgoing life insurance has no potential benefit.
Ideally you should only maintain risks that offer more upside than downside. Look for asymmetry in your bets. A bet is worthwhile if the upside greatly exceeds the downside, and you could stomach the downside if it happened.
Managing Risk Exposures
After you’ve addressed the worst of the downside exposures, you can focus on upside exposure and Rule 2 (take risks in pursuit of your desired experience). First, let’s return to the idea of plotting your desired lived experience over time. Some of those desires are non-negotiable - maybe that’s full college funding for your kids, or the ability to stop full-time work at age 50. Other goals are more aspirational. Risk should initially be taken on to increase the likelihood of hitting your necessary return on investment (of financial capital or human capital) to satisfy the core goals.
If risk capacity still exceeds risk tolerance you can layer on more volatile bets. If these bets work out you are able to fund the nice-to-haves, but your whole plan won’t blow up if they fail. With this structure in place you are not relying on a volatile bet’s success or failure to fund your non-negotiables.
Practical Risk Planning
When we talk about risk we talk about it in practice, not in theory. In real life it’s impossible to know exactly how much risk you “need” to take to meet your goals. If you knew how the future would play out, there’d be no risk at all. For this framework to be useful, you must periodically consider the total risk inherent in your life - how have you allocated your financial capital, your human capital, and your time? Where could things go wrong? And if those things do go off track, what sacrifices would you need to make?
Asking these questions can help you intuit whether your risk capacity exceeds your tolerance and necessity. If you are out of alignment, look at ways you could establish a higher baseline by eliminating downside risks. You can also check in with trusted professionals to help identify blind spots in your risk exposures. Then, once you’ve locked in what needs to happen, you can focus on those bets with asymmetric upside in pursuit of what could happen.
