Managing risky business

Several years ago, I gave a talk at UNC Kenan-Flagler Business School. I told the story about starting my own company, taking on millions of dollars in personally guaranteed debt, and staking my young family’s future on the success of my new company.

I explained that if you look up the word “entrepreneur” in the dictionary you will see that it is defined as one who “initiates and takes risk.” Someone in the audience asked, “How did you justify taking the risk of starting your own company?”

My answer was this: through experience. I had become confident in my ability to take, manage and mitigate risks. I was less worried about having my future be in my own hands than having it in the hands of someone else.

As a business owner, understanding risk is critical. Here are four business principles you need to know.

Profit margin

I had a good friend who owned a large chain of grocery stores. In the grocery business, profit margins are very low, typically in the 1-2% of revenue range. In other words, you have to sell $1 million worth of groceries to make a profit of $10,000 to $20,000, which makes for a high-cost, low-margin, high-risk business.

When Walmart and Amazon decided to get into the grocery business in Phoenix, my friend had to compete with them and his narrow margin turned negative, forcing his business into bankruptcy. With margins so small, his business had no room for unexpected changes. The rewards no longer justified the risks.

Probably the easiest way to measure the risk of a business decision is to evaluate the profit margin you expect to achieve versus the risk (exposure to loss) you might encounter.

In the homebuilding business, before we would commit to buying land for a new project, we calculated the realistic revenues and costs to determine the expected profit margin. Usually this margin was between 5% and 10%. The higher the expected profit margin, the lower the risk. Anything under 5% was out and anything over 10% was a go. But if it was between 5% and 10% we dug deeper into the details to see how we could get to an expected profit margin of 10%. If we could, we moved forward. If not, we passed.

Margin of safety

Before you buy in to a risky venture, do your homework to uncover things that could go wrong. Once you have done this, you are better prepared to understand and deal with any adversity that comes your way.

To understand the concept of margin of safety, ask yourself what you stand to lose and how much is safe. If you’re playing blackjack in Las Vegas and put $100 on the table, you stand to lose it all, so your margin of safety is zero. If you are investing in a stock, your safety margin is probably in the 80% range and gets better the longer you hold it.

When the housing market in Phoenix crashed in 2008 and prices dropped more than 50%, shrewd investors quietly bought thousands of houses, some for as little as $30,000, and leased them to people who were afraid to buy. Five years later, the investors could sell the houses for big gains.

Why did they take this risk? When they looked at the bet they were taking, they could see prices had already fallen well below replacement costs and couldn’t fall much more. And if they did, it would probably be less than 20%, so their margin of safety was at least 80%.

Because they could easily cover their holding costs by renting the homes until the market recovered and their margin of safety was 80%, they saw a very safe risk and capitalized on the opportunity.

Return on investment

Probably the most basic way to look at risk is with the return on investment principle. In financial markets, the expected returns are based on the perceived risks in each investment category. For example, the expected annual returns for five- to 10-year bonds are in the 3% range, while the expected annual returns for most stocks are in the 6-8% range as they are more volatile. Your return must be relative to your risk. The bigger your risk, the bigger your return should be, and potential benefits must exceed potential costs.

When I was a partner at Trammell Crow Residential in the 1980s, we had a very simple way of managing risk. We knew if things went badly we would lose 100% of our investment. So, to justify the risk we tried to achieve at least 10 times our investment. This was a high mark that we rarely hit, but it helped us stay out of trouble.

Volatility

The “Sharpe ratio” was developed to address volatility in the stock market (standard deviation) as a risk that required investors to seek higher returns. The concept is that higher volatility (large swings in value) creates more risk that should be rewarded in the long run by higher returns. The more stable the investment, the lower the volatility, the lower the risk and the lower the expected return.

The higher the Sharpe ratio, the more return investors can expect to receive in return for the extra volatility they are exposed to. The Sharpe ratio message is clear: change, uncertainty and volatility provide opportunities for taking smart risks that earn higher returns.

You can’t go through life without taking risks. Be the person who strives, takes smart risk and gives it your all. And when you lose, as you sometimes will, get right back up and into the arena. That’s a life without regrets and a life worth living.

This article is based on “Solid Ground: A Foundation for Winning in Work and Life” by Lewis. Also read his insights on what it takes for entrepreneurial success.