I read Nate Silver’s On the Edge on a recent trip to the California desert. The book isn’t really about entrepreneurship or small business ownership per se. The book talks about people taking risks and getting rewarded.
But Silver’s book? The risk management tactics and tricks he describes gamblers, casinos, venture capitalists, and artificial intelligence developers taking? That stuff is pretty applicable to small business owners, too. Thus, I’d recommend putting On The Edge on your reading list. And in case it takes you while to get to the book, let me spotlight a handful of interesting risk management ideas.
Idea #1: Most People Take Too Few Risks
A first idea backed up by a bunch of research: Most people take too little risk. Poker players, investment traders, entrepreneurs, and so on.
And why this matters: Unfortunately, avoiding or dodging risks? A destructive and unprofitable habit or practice.
The actionable insight here: Most of us (me included) take too few risks.
Idea #2: Testosterone Levels Affect and Are Affected by Risk
A second thought-provoking idea from the book: Testosterone levels are linked to risk-taking.
For example, people (yes, mostly men) with higher testosterone levels tend to take more risks. And because most of us take too little risk? That effect of higher testosterone might actually be a good thing.
But something else to note: According research Silver reviews and discusses, successful risk-taking boosts testosterone. So some people can experience a compounding here. Higher testosterone levels amp up risk-taking. (Initially good). That risk taking results in rewards. (Again, good.) Those rewards boost the testosterone. (So far, so good.) That triggers more risk taking. (Okay maybe good…but at some point not good.)
In any case, something to consider. Especially if you’ve just experienced a massive boost in your testosterone levels because you’re coming off of a giant success.
Idea #3: Cortisol Levels Affect Risk Tolerance
A related hormonal issue: Anxiety levels and cortisol stress hormone levels affect people’s risk tolerance.
So this actionable insight: Stresses and anxieties from stuff outside of work? That can obviously push down our ability or willingness to take risk. Which makes sense.
But if risk-taking and harvesting rewards from managing or bearing risk is one of the things entrepreneurs do? Maybe small business owners and entrepreneurs need to think more about the anxiety stuff.
Idea #4: Putting Money Down Often Problematic
An idea that jumps off into another area.
In talking with gamblers taking risks and also with venture capitalists, Silver talks about the challenge of actually finding opportunities to bear risk smartly.
A handful of times in the book, he talks about the challenge good poker players face trying to find good games or tournaments to play in. Or about sports betters struggling to find online gambling shops willing to take their bets.
I see a connection here to you and your small business. (I’m assuming your small business is or will become successful.) And the connnection is this: Yes, you should be earning great returns on your small business investment. Way better than you’ll earn if you “cash out your chips” and then invest in the public captial markets. Thus, you (and I) want to think very carefully about taking money off the table so to speak.
You and I may want to let our winner continue winning.
Example: Say your small business generates $200,000 a year in profits and that you could sell the firm for $500,000. (That would reflect a common valuation.) Viewed from one perspective, you’re earning a 40% return on your investment. If you cash out the $500,000 and invest in the stock market? Well right now, with the current valuations of US stocks US investors might earn $10,000 to $20,000 annually. You therefore may want to keep your money invested in your small business.
Idea #5: Kelly Criterion Suggests When to Sell?
A final risk-taking insight: A formula from the world of gambling and then (oddly) finance, the Kelly Criterion, suggests how much you or I should have invested in a small, high-risk business.
Assuming the entrepreneur is fully risk tolerant, more on this in a minute, the Kelly Criterion for fractional wealth allocation to a risky asset like a small business is:
(Expected return – Risk-free return)/(Volatilty2)
This formula looks complicated. But the math works more easily that you might expect.
Example: Say the return you expect from your small business equals 25%. Say the risk-free return you can earn from US treasury bonds equals 5%. Finally say the volatility, or standard deviation of your small business’s return, equals 50%. (These numbers are all pretty accurate guesses in many cases, by the way.)
With these inputs, the Kelly Criterion formula looks like this:
(25%-5%)/(50%2)
That 25%-5% numerator equals 20% obviously. Thus, the equity risk premium equals 20%
That 50%2 denominator equals 25%.
And 20%/25% equals 80%.
Thus, risk tolerant small business owner might rationally choose to have 80% of her or his wealth invested in a small business that generating a 25% return with 50% volatility if riskless assets return 5%.
Note: We’ve got an earlier blog post about Merton shares which work identically to the Kelly Criterion in this situation. That blog post provides a calculator and additional background information on how you come up with the formula inputs.