Specific risk, as we saw before, is the risks of a specific investment. Our review of how this is handled in capital markets, where the focus of analysis is the specific risk of a particular equity for instance is worth revisiting.
The specific risk of an equity is driven by the observed volatility of the stock price relative to the rest of the market. The theory calls for the comparison to be made to the risk free rate of return, and the problems start. What is the risk free rate of return benchmark (a comparison standard). In some analyses, this would be an investment that is free from risks from all sources – systemic, systematic, and specific. Some argue that the only investment that matches this has a return of precisely zero – invest in a sock under your mattress. I disagree; a sock under your mattress has a negative return, due to inflation, and the risk of theft!
(Very amusing, now try being serious.)
One standard that is used is government T-bills; others use certain government savings bonds. These are however exposed to interest rate risk, which in turn is governed by systematic risks of the economy as a whole. This is NOT however, the risk free rate of return that is used in this theory. What is used is the comparison to a fully diversified market portfolio. Let us consider an index fund. One can buy units in a mutual fund that is not managed, and instead, simply holds a portfolio of stocks across the entire exchange spectrum – by definition, a fully diversified holding. The fully diversified nature means that the risk coefficient is 1 – completely neutral and so, “risk-free”. In effect, the risk free rate of return is equal to the market rate of return. Looking at this value on a historical basis can give you a number. Let’s say that over the past three years, the rate of return of our index fund is 15% a year on our investment. This will vary with the historical window used, but bear with me.
What are the assumptions?
How about that the market is rational . . .
What exactly does that mean? Every investor believes that they are rational, and they are, based on their unique model of reality, and how they believe that things work. Since two rational investors can hold completely opposing views, they can view each other as simply irrational. The process they use may be rational, and yet also be simply wrong.
How about the separation of the financial and production worlds?
This is simply ludicrous. Not only are they not separated, the financial world is the shadow of the production world.
How about the belief that the historical volatility of a share price is a reliable measure of the present day volatility or risk of the investment?
This is lunacy – the world changes sufficiently on a daily basis that an organization is not the same in May as it was in April, let alone last November . . .Nor is the environment within which it operates the same.
Why on earth do intelligent people spend their days examining such things? A long time ago, people would gut a sheep and examine its entrails to predict the future. This falls into the same class. It is simply a need to believe that they have a valid model to understand the world they live in, in order to FEEL that they have some measure of control. Casting the auguries with the rho of risk, or the beta co-efficient is no better than older forms of witch-doctoring.
Now, how does this help the independent entrepreneur? It doesn’t, but I enjoy studying delusions. First of all, there is no market to track the price of your independent business; since there is no price, there is also no measure of volatility relative to the market, and so no rho, and no beta co-efficient. Feel better now?
Here’s how it CAN help you. You have an investment decision to make. Do I invest in this new equipment, that new product line, the other new person . . .Evaluating the price of that investment in relation to your market’s rate of return and risk profile is worthwhile.
Let’s suppose that you have a business. You invested $25,000 in start-up capital, and a month ago, you were offered $50,000 to sell the business. In the past two years it has generated some $15,000 per year in after tax returns on your investment, after a fair market wage paid to you for your services. This makes the historical return a 30% return on the fair market value of your investment. The stock market returns for the past two years has been 14% based on an index driven mutual fund.
You have two choices in front of you right now. The first is to invest in a new product line from ABC Products to distribute through your existing channels. The investment would cost $10,000, and your estimate is that you would gain an additional $5,000 after tax – a 50% return.
Your second alternative is to develop your own additional product line to push. You think you could develop this for $5,000 invested, and that it would return $5,000 after tax – a 100% return.
Which is better? You make a list of pros and cons. Amongst the cons for your own line are that the product items are unproven, that there is a longer time line to get to market, and that you would be competing with the already existing product line from ABC Products. The cons for adding ABC Products is that your margin is lower, and you are giving ABC some control over the line, in that you cannot customize the product.
You quantify the risks. The likelihood is that the probability of success in adding ABC Products line is three times the alternative of developing your own line. This means that the probability-weighted return of ABC Products is 50%, but your own line is 33% [100% x 33% probability]. Compared to your existing risk of about two times market returns, both are acceptable, but the margin for error is small for your own line.
What can you do to change the risk profile of the two alternatives? The risk profile of the ABC Products alternative has very little scope for change, since most of the factors are still in ABCs control. Developing your own line offers greater scope for risk reduction. Taking the cons for your own line in turn, you find that
You have three key customers who can assist in greatly improving the prospects of pre-proving the product line, and they are also prepared to commit to carrying the new line.
The time to market, you find, can be improved by subcontracting the prototype assembly to another company, at an additional cost of $2,000. This will permit you to have product ready for the seasonal window.
Lastly, the work with your distribution channel customers will permit you to localize the product offerings to make them a better fit with the customers needs – thereby giving you a competitive advantage to offset ABC Products existing market presence.
The revised risk profile means a $7,000 investment for a $10,000 annual return. The risk profile is now neutral between the two alternatives – in fact, your best estimate is that your line will have a competitive advantage making it LESS risky than taking on ABC Products line. Your choice is now a 50% return (ABC Products) as against a 70% return (your own line).
Now bring it home. Your traditional risk rate of return is 2 times market rate – 30%. This specific project offers a 70% rate of return, which means that it can be twice as risky as your existing operations, and still be justified. Better yet, if you can reduce the risks further, you improve the overall picture of your operation.
The purpose of risk evaluation for independent businesses is to assist in refining investment plans for projects within the business. Given alternatives, what are the risks and how can you reduce them. Different options have different potential risk management possibilities, and THAT is what must guide your decisions.
5 Comments
Gut a sheep and forecast the future. Ridiculous. Everyone knows that you are supposed to use fish for that, preferably carop. Why do you think asian culture keeps those ponds with the carp in them. Its so they can forecast the futures of their businesses. Pilot, with every post you further confirm my opinion that you are not fully sane.
Fact is, you and the rest of your MBA friends do these math things that is really not one bit difference than fondling entrails. You get it wrong more often than not. And your little stories are all written to prove your point, and that is just a bit too easy. The real world is messy, and complicated, and whatever kind of math it uses, ain’t the one you guys use.
Drinkwater you are the light in my life! Why is it that I put up with you and don’t ban your obnoxious hide? Oh yeah, its almost like you were an in-law or something.
What is carop - is that newly discovered prehistoric fish? Oh I see, carp… Oh and sanity is highly overrated, I mean look at your success!
Don’t forget, long before there was an MBA with my name on it, there was decades of business start-ups and turnarounds. Agreed that many MBAs would benefit from gretaer experience, but you have to remember that a lot of them are not training for being an entrepreneur, or even general business, but to go into a trade like stock brokerage, or product management, or even accounting and corporate finance. Do you sneer at a plumber because he wasn’t trained in electrical code?
Of course my stories are written to prove a point, or at least to illustrate a point. I don’t use real life cases, because that is a breach of ethics. Would you like me to disclose your business details to other people on the internet? Didn’t think so.
Messy - I guess. so when the dog does his business on your carpet, do you simply clean it up, or do you train him to go outside. As for math, we are getting there. Some people who don’t care for math (sound familiar) need to be brought along gently. We’ll get to Brownian motion and the random walk theory soon enough. We’ll see what you have to say then, shall we !
Drinkwater . . . sigh
Pilot - “you quantify the risks” . . . you palmed that ace in plain site. Quantify HOW. What, you want me to guess here is that it? Problem is my judgement is often no very objective, because I believe in my projcets, and I expect them to work out favourably. some days, my view is that my projects are almost done deals - no risk at all here, move along!
Hope you put some meat on that bone, bud
Umm, there are a bunch of tehcniques that assist you in reducing the subjectivity iof your risk estimations NEMO. I often use a fishbone analysis to chart decision tree processes. I attach a guesstimation probability at each successive branch, and at the end of the branch, I either put an outcome amount or cost, or another branch. Multiplying the successive branch probabilities tells you what end probability there is for each outcome. It still has some subjectivity, but at least there is specific questions to guess at, instead of some overall gut feel. It improves my initial judgement a lot. Surprising in fact how often I am able to improve what I thought were bad risks, to things that can be managed successfully.
Worsel, that is one approach that works, for some situations. Sometimes though, branches are interdependent, or lead to very similar outcomes within the range of tolerance. In those situations, it is a little harder to apply. Nevertheless, a useful approach.
Iam working on a post now about the technique that I use as a first cut for a lot of what I call pre-feasibility reviews. To be honest, I use it during first presentation pitches from other people, when I am asked for my opinion. It is a good first start too. Should be up tomorrow, with any luck.
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