If you have a negative emotional reaction when you hear the word “risk” you are not alone. Yet, every important decision we make entails some level of risk. You can’t have any gain without taking a risk. Accordingly, it is imperative that we know how to recognize and evaluate risks, and take them in a smart way to achieve our greatest aspirations.
Knowledge and Instincts are Powerful
Investing always has a component of risk because we cannot predict the future. We have to make our decisions based on what we know from past experience, data points and “rational" thinking. In the process of investing, we inevitably hit the limit of what we know or can know. Then we move to a combination of our “best informed guess” and our intuition to help us decide on a course of action. We inevitably consider if we can live with the worst we can imagine no matter how unlikely. We balance a reward that we want against uncertainty and any possible negative outcomes. Most times we are not aware of the computing our brains do to consider both the upside and downside of any course of action.
As decision makers in our professional and personal lives, we use our ability to sort through information and make choices all the time. We factor in what we like, what matters most to us, and what we stand to lose with every important decision. We make decisions all the time in life with incomplete information - when we decide to take a job, enter a relationship, have a child. There are things we cannot predict or know. At some point we take the risk, the leap of faith and just decide to move forward. Our decisions are made with a combination of rational and emotional inputs based on imperfect information. We take a risk, experience the outcome either good or bad and carry on. Such is the process of life and learning.
So why does investing seem so different, so hard, so opaque and so non-user friendly? Perhaps it is the way the financial services industry has made investing seem complicated and disconnected to our emotions and values. The reality is that it’s not that complicated.
We just need to understand the risk and reward tradeoffs, which are the crux of investing. How much risk should I take for what I might get back? How much money am I prepared to lose and how much money might I make? We also need to trust our instincts.
Understanding Risk and Reward
A simple fact is the more risk you take, the more the potential pay-off. It’s also true that not making a decision to take risk (or not taking action as an investor) is perhaps more risky. By being overly cautious or non-decisive, you elect to forgo opportunities that will allow you the chance to make a profit by using your money.
Conventional wisdom advises us to build a diversified portfolio of public market securities to make a return. This approach has historically proved advantageous offering long-term returns in the 8-9% range. However, investing in the public markets is not without significant risk. Just think back to 2008. If you had money in US stocks at that time your portfolio dropped and lost significant value in a few weeks. Our financial system and economy were on the edge of a cliff after the Lehman bankruptcy. Public market returns evaporated and many lost their retirement money. The good news is that the market climbed its way back to the level where it was prior to 2008. But, it took 4-5 years to recover and if you needed your money and withdrew it along the way, you lost money.
Recent research has shown that it is increasingly difficult to generate meaningful wealth creation through diversified public market investments. History shows investors can achieve long-term life goals like saving for retirement or college education with long-term investing in pubic market equities but significant wealth creation has been limited with those investments. This is why so many institutional investors (corporate pension funds, endowments, family foundations) and high net worth individuals are increasingly allocating more capital to alternatives to the public markets in investments like private equity and venture funds that involve greater risk but offer potentially higher returns.
While investing in the private markets is risky, calculated risk can be worth taking for the returns. The below data provided in a recent report by Cambridge Associates shows a comparison of venture capital fund returns (diversified exposure to private companies) at various times in the last 25 years compared to the S&P 500 Index, which is a general proxy for the US public equity market.
The chart shows how lucrative early stage investing can be compared to the public equity market.
The disappointing part of this is that only institutional investors and a small number of individual insiders have access to investing in the best venture funds and the opportunity for real wealth creation. Plum Alley Investments and our members believe a broader set of investors should have access to participate in investing in the companies of the future for financial and other returns.
Evaluating Private Company Risk
Investing in private companies of course entails risk. To be confident as an investor, you have to identify the risks, understand and assess them and then make a decision. Our goal is to offer a straightforward framework to appreciate risk and let it work for you to achieve more money, options, influence and impact.
With private company investing, the risks fall into two major categories: risks associated with the company and risks associated with private company investing. As you think about investing in private companies consider the following to understand and evaluate some of the key risks so you can be clear and confident in making your investments:
Private Company Risks
Stage of company - An idea on a napkin is a greater risk than a company with a proven product and revenues. As you move up the life cycle from angel (first money in) to later stages, your risk declines as a company proves product-market fit and gains traction with paying customers validating the concept.
Ability to raise capital - High growth companies with limited profitability generally need multiple influxes of capital to grow and seize a huge opportunity. Most companies close down because they are not able to access additional capital to realize their full potential.
Competition around every corner - The founder and company must have something unique to offer that sets them apart-- things like special expertise, intellectual property or first mover advantage.
Founder and team capability - The team must have relevant skill and expertise to execute on the vision.
Private Market - Sector Risks
Liquidity time frame typically 7-10 years - It takes most early stage companies at least 7 years to find the optimal strategy and build the company to a point where it has ways to make a return for investors.
Risk consideration: If you approach your private company investments with the concept that it will take on average 7 years to determine the return, then you have a buy and hold approach automatically built in with this type of investing. Compare this to investing in a retirement account which is likely to be on a long- term basis in public securities with a duration of 10 to 20 years to ride out market ups and downs. Investing in private companies is usually a mid-range investment and not a short-term hit or long-term strategy.
No established market to sell your investment - Illiquid investments mean you have to hold your investment because of limited outlets to sell your position. You will only get your return if and when an event happens like the company merges with another company, becomes a public company with an IPO, or returns money to you in the form of a dividend or some other form of profit sharing.
Risk consideration: There are some new platforms that have launched to deal with the problem of liquidity like SecondaryMarket so more options may be available in the future.
Concentrated risk if only one or two investments - One of the tenets of investing is that you need a portfolio approach whether it is in the public or private markets. If you only make one investment in a private company you are unlikely to pick the one company that will be a superstar or homerun just like you are unlikely to pick the one stock in the public markets that will outperform the others.
Risk consideration: The recommended approach is to diversify and invest in several companies. Diversification is a best practice in public market investing and it holds true for private company investing as well. You need several companies in a portfolio. There are also ways to diversify equity and debt.
Limited company information - There is different information available for private companies compared to public companies. Early stage companies may only have projections with assumptions as they typically do not have an established track record. There may be cases in which there is no history - or limited history - or the company is evolving so rapidly that the future holds more promise than the past. However, even with audited financial statements and numerous years of history, a public company may face unexpected problems or competition and render the past no longer indicative of the future.
Risk consideration: With rapid innovation and new competition in every industry, looking forward may be more beneficial than looking at the past. In all cases, an investor should never proceed if they are not comfortable with the information provided.
We will never eliminate risk in our lives or in our investing and, in fact, we don’t want to. Taking risks in life is what enables you to learn and grow. Taking risks with your investments is what enables you to make money. When you think of risk as a partner and something to bring into play at your command, you can achieve many benefits. Most of us already have what we need to assess risk—our brain, intuition, values and aspirations. What we need is a framework and the conviction to take action.
Our decisions as investors are personal and should reflect our deepest desires and values. Financial risk and reward are a critical component of investing but they are just one component. Beyond the financial return is the personal return we seek by making choices with our money (more articles will come on this topic). Taking smart risks provides us the way to participate in wealth creation and use our voices and capital as levers for shaping the world ahead.