Risk Exposure vs. “Good” Outcomes

If you jump off the roof of your house and survive uninjured, was that a good decision? Or phrased more appropriately, was it a risk-free decision?

Intuition would tell you that you were exposed to risk, even if you didn’t get hurt.

I first learned about risk from McKinsey’s Financial Institutions practice.

I spent a lot of time in risk-management-based businesses such as insurance, reinsurance (the insurance companies used by insurance companies), and subprime lending.

Risk-based businesses are very unusual in that you know your revenues today, but find out your costs ten years later.

As a banker, you might lend a borrower money to buy a house. You know how much the borrower is expected to pay you each month for the loan.

What you don’t know is if they will continue to make their payments ten years later.

If they do, you’re profitable. If they don’t, you lose a ton of money.

The former happened in 2007 (the year before the Great Recession). The latter happened in 2008 (the cause of the Great Recession and stock market crash).

The layperson thinks 2008 was a “bad” year.

A person who has a more sophisticated and nuanced understanding of risk understands the risk EXPOSURES in 2007 and 2008 were not all that different.

In both years, the risk exposure was excessive.

The only difference is that there was a “good” outcome in one year (2007 with no stock market crash) and a “bad” outcome the following year.

The most important thing to appreciate about risk management is that the outcome you happen to experience in any single moment in time is often NOT an accurate measure of your risk exposure.

The key to managing risk is to appreciate the level of risk you’re taking (and the magnitude of a potential loss) and compare it to the likelihood of a win (and the magnitude of a winning outcome).

My favorite kinds of risks are those where the probability of a win is modest, the rewards are high, but the magnitude of any loss is small.

Examples of this include:

  • Minimum Viable Product (from Eric Ries, author of Lean Startup)
  • Using Kickstarter to finance a business
  • Using surveys to determine interest in new product offerings before building the product (what I do for new classes I teach)

In my own company, clients’ companies, and portfolio company, we are constantly running many experiments... taking risks with very small potential losses, in search of a winning strategy with a high upside.

About 80% - 90% of the time, these experiments fail. However 10% - 20% of the time, they work and work pretty well.

This is one form of calculated risk MANAGEMENT.

Taking big risks recklessly versus taking well-managed risks are two entirely different things.

This thinking applies to your career.

  • If you’re choosing between career Option A vs. B, does pursuing one option eliminate the possibility of coming back at a later time to pursue the other option?
  • If you take a job offer from a startup, can you later work at McKinsey? If you take the McKinsey job offer, can you later work at a startup?

This thinking applies to major medical decisions.

  • If you have two treatment options, if one option fails, does it kill you or merely not give you the benefit you were seeking? It’s important to understand this aspect of risk before making the decision.
  • If an experimental drug merely might not work, that’s one thing. If it may kill you, that’s an entirely different thing. It’s important to know the difference.

The four key factors in understanding and managing risk are:

  1. Probability of good outcome
  2. Magnitude of good outcome
  3. Probability of bad outcome
  4. Magnitude of bad outcome

If you don’t have either a quantitative or well-informed qualitative assessment of these factors, you aren’t managing risk. You’re merely being exposed to it... perhaps recklessly.

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