It’s High Risk to Be Low Risk
Risk is fascinating because there is no standard way to measure it. I’ve said before that in a world where everything can go to zero, there is no medium risk, and I believe that.
But I also acknowledge that risk is a perception and a concept that is related to ability, resources, goals, and objectives. What’s risky to you might not be risky to someone else and vice versa.
For example, audiences marveled at performer Harry Houdini when he had himself thrown into the East River… handcuffed… and in a crate. That seemed insanely risky. But Houdini knew how to escape and did so in 57 seconds, which made it a relatively low-risk walk in the park for him.
A financial equivalent of this is how younger people are told to buy stocks for more return and older people to keep bonds and cash for more stability, as if age explains all needs. If you have years until you need the money, it makes sense to risk volatility to make more money. If you need the money now, it makes sense to risk lower returns to have more predictability.
Yet just as Houdini’s line of work eventually contributed to his death, the universal truth about risk is that the amount of risk you are or are not taking will eventually catch up to you.
One observation about risk is what I call the OPM problem. OPM stands for “other people’s money,” and the problem with it is that people tend to take more risk with other people’s money than they would with their own and that this creates massive and systemic problems.
The dot-com bust was an OPM problem (venture capitalists were allocating other people’s money) and so too was the mortgage crisis (banks were lending other people’s money). More recently, the blow-ups in crypto were also OPM problems.
But just because someone is willing to give you money at low cost, doesn’t mean you should use it to chase returns. That sounds obvious when one says it, but the temptation to use OPM to make money is tantalizing. After all, what’s nauseating about the financial crises mentioned above is that for the most part the people who originated the mess didn’t end up suffering the consequences.
But doesn’t Permanent Equity invest OPM?
Yes, we do, but we’ve tried to structure our partnerships in ways to avoid the OPM problem. We charge no fees for our work until we’ve generated performance (so we’re not incented to do anything stupid) and if our performance ultimately implodes our partners can claw back any fees we did take (so we’re not incented to do anything unsustainable).
On the flip side, because a small business owner’s wealth is mostly tied up in their business, we’ve seen many inadvertently take on massive risk by trying to take a lower-risk approach. This manifests itself in older owners making less reinvestment in their business in order to keep it stable and cash-flowing under the auspices that they don’t want to upset the apple cart so late in their careers.
This sounds like it could make sense, but when you consider your business as an asset, it exists in a competitive ecosystem and isn’t guaranteed to hold its value. If you stop investing in yours and others keep investing in theirs, yours will start to lose. Or as the writer William S. Burroughs put it, “When you stop growing you start dying.”
The insidious thing about this fact is that it’s not immediately visible. The effects of people competing against you are a lot like potential energy. They get stored up until there is an event – like a major customer deciding who to award the next big contract to – that releases them. Then all of a sudden your stable enterprise finds itself in a crisis because you thought you were making low-risk decisions about growth and capital allocation.
The key is to remember that risk has negative space. Every risk you take, has a risk you’re not taking and every risk you don’t take, means you are taking another risk. If you’re aware of that fact and can identify what you’re not seeing in addition to what you are seeing, it makes it possible to manage toward better and more reliable outcomes.
– By Tim Hanson
