• “Risks have to be compensated”
  • “There is a difference between idiosyncratic and systematic risk”
  • “This return does not cover the huge risk I’m taking”.

These are just three of the common statements about risk that everyone, sooner or later, encounters. But what is risk? And why is it so important? Understanding the concept and the importance of risk is pivotal for a startup approaching VCs. With this article, we try to answer the two questions above and to give a broad understating of financial risk.

 Risk Identification

In general, risk relates to the fact that future cash flows, or earnings, are not a given. They are volatile, meaning the amount is uncertain. We can make estimates about them, but we cannot be sure. When an investor takes on more risk, that is, their future earning are characterized by greater uncertainty, they must be compensated by a higher return on the investment.

To clarify the matter we can use a simple example: Suppose that we two investments. Investment A is a risk-free investment, meaning that the amount we will get in the future is certain and stable and will pay off $1050 into the future. We are willing to give $1000 now because the time value of money is compensated by a return of $50, or 5%. Investment B is volatile, and the return is more uncertain. Half the time, it pays $1100 and the other half it pays only $1000.

With half of payoffs at $1100 and half at $1000, Investment B has an average payoff of $1050 – the same as Investment A. Thus, it is only logical $1000 is an appropriate investment for this gain, right? Wrong. If both investments are possible, rationally we are more willing to give our $1000 to the first guy, earning the same average amount for sure. This implies that the second guy will only be able to raise financing if he adjusts his asking price to less than $1000 or compensates the added risk with a return higher than 5%.

In short: for any given investment, greater variability of outcomes for returns on investment must be compensated with a higher rate of return to offset the increased risk.

Diversification:  avoiding the “all eggs in one basket” approach

Now that the general picture about risk is clear, let’s talk about diversification and the part of this risk that should not matter to an investor.

In this case, diversification means not putting all your eggs in one basket – but why not? The reason is simple: if your basket breaks, you do not want to chance losing all your eggs at once. On average, you will lose some of them, but by spreading your eggs across different baskets you reduce uncertainty, and can better estimate and control your losses.

Insurance companies are an excellent real-world example of spreading risk. Suppose that you are starting an insurance company that provides fire insurance for homeowners. You know that one average 1 in 10 homes will be damaged from fire each year. You have two options: Start small, insuring only one house, or grow large, and insure 10,000 houses. The same risk – 1 in 10 fires – impacts each of these strategies differently. If you are the small firm, you may have up to nine years of great business with no claims, just profit, but by the tenth year, your only customer’s home goes up in flames. The huge claim drives your firm into bankruptcy. If you are the large firm, an average of 1000 of the 10,000 homes you insure experiences a fire each year. However, consistency in claims and profit allow you to balance your premiums and maintain solvency because for every 1 customer costing you money, 9 customers are bringing you money.

This also works with companies and is one of the main theories in finance. Every investor should diversify. Why? If you buy 1 stock of 10,000 companies you have way less uncertainty than buying 10.000 stocks of one single company. By reducing uncertainty, the return you require to invest in one of the 10.000 companies will also be lower. The resulting unique risk that your portfolio of 10.000 companies has is a risk that affects them all. A risk that decreases the prospects of profits for all your 10.000 companies. That risk is commonly named “market” or “systemic” risk.

Risk Definition: systematic risk v.s. specific risk

The risk above is that of an adverse business cycle, a crisis, a meltdown: something that is not averaged out by the huge number of companies of your portfolio. But what about the guy that bought 10.000 shares of one company? He is affected by risk in two ways. First, he has a lot more uncertainty than the other guy. The company is exposed to the same market risk than the others and it can still get hammered by financial crises or bad business cycles. Furthermore, he is exposed to all the specific risks that a company has. These risks are not averaged out by the other 9.999 companies of the portfolio as in the case of the other investor. The value of the stocks can decrease for a whole lot of reasons. The CEO can get arrested, steals, is ignorant of a market development or the company can burn!

The second way is through returns. Does this guy get a higher return from his investment given that he is bearing the specific risk of one single company? The answer is no. The smarter investors that diversified bought a lot of stocks of each company and the price rose. For this reason the returns cannot be high for the undiversified investor. He has to buy the stock at the price decided by the market. And the market knows how to diversify.

Profits from specific risk are non-existent

The final point I want to make with this article is that the specific risk of a company should not be tied to a return. The only risk that matters is the systematic risk or how future earnings are sensitive to the state of the economy, how the company is affected by bad business cycles and crises. All the risk that is not common among companies can be averaged away (diversified) buying a portfolio of different securities.

Risk is an important concept in finance and in business. It is important to understand why and how it is compensated by returns on your money. Often, the owner of a startup is not really diversified. A large part of his money is tied to the future developments of the business. It is invested in the business.

Usually the investor owns stakes in several companies. His risk when investing in your business is averaged out by the others. He knows that on any given year, 25% of the companies in his portfolio will lose money or go bankrupt, but he also knows that the others will perform and some of them outperform. He has far less uncertainty about his whole portfolio and he requires a lower return on his investment in your company compared to how much you, as an entrepreneur, should require. However, he is not going to tell you this, he is going to require high return even if he is diversified! So take this lesson by heart: risks have to be compensated by returns, but if your eggs are in different baskets, you know more about what to expect the next day!

Following up questions:

  • How diversified is your portfolio?
  • How can I improve my valuation lowering the perceived risk of my company?
  • How does the bankruptcy risk get into this framework?
  • Is there a way to calculate the required return on an investment in my company?