On the Matter of Risk & Return

Not a day goes by where I don’t come across a disconnect between a business owner’s understanding of the concept of risk and return as compared to a potential lender or investor.  The business owner typically has their view of risk because they are intimately involved in it. They believe they can manage through it and are focused on the return side of the equation.  The potential lender or investor usually sees it differently based on their frequent experience with that type of risk profile.  Even with experience, the potential for miscalculation exists.

 Let’s define risk in its most simplistic term: uncertainty.  The greater the uncertainty of an outcome the higher the risk and thus its cost.  Anything either interested party can do to reduce uncertainty will reduce the risk and its cost. 

There are several factors impacting our understanding and/or interpretation of risk: 

Time has an interesting effect on risk. No one knows what the future will hold.  While short term predictions are generally more accurate, longer-term ones are not. The further a lender or investor must wait for an outcome the higher the risk and thus the higher the return required to satisfy them.

Knowledge and understanding also play a role in assessing risk properly and pricing it accordingly.  Ignorance will definitely result in improperly assessed risk and return.  Never compare an ignorant investor or lender to one that knows your business and industry well.  While you may benefit from this gap in the short run you will eventually pay the price for this when you can least afford it.

Speed inevitably increases risk.  If one is asked to make a quick decision, odds are they will overlook something important or make a mistake.  There are people who narrowly specialize in what they do and are comfortable with speed but that too comes at a heavy cost.  The heightened cost reflects the recognition that such behavior will eventually lead to a loss.

When given a specific time frame to underwrite a transaction, with the benefit of knowledge and the absence of speed, an individual can properly assess risk and price it properly.  In an efficient market, pricing is established by those that have the benefit of those variables.  If you feel there is a disconnect between what you expect and what you are being offered, consider asking yourself: what is missing?  Is it my understanding of the risk or is it theirs?  If the pricing seems wrong that is an easier problem to address, the market will determine that. A competitive bid process will solve for that.

 Next up: What should a competitive bid process achieve?