Imagine for a moment that you are pitching an investment opportunity to a fund manager – a hard-nose investment professional.
You paint a picture of the opportunity and highlight the potential returns they should expect if they commit their funds.
You tell them that for an initial outlay of $1 million, they should receive $1.5 million over the next six months. A 50% return.
I can guarantee you exactly what their next question is going to be about your proposition: What’s the risk?
Getting a high return is great, but it needs to be considered in the context of the risk of the opportunity. Looking only at the potential return gives an incomplete picture.
Making $10 million on a $100,000 initial outlay is great. It’s a 100-times return. Who wouldn’t want a piece of that?
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But if the person putting the proposition to you also said that there is a less than 1% chance of you actually earning that kind of return, you would think long and hard.
Indeed, an opportunity that offered a $750,000 return with a 40% likelihood is arguably the better investment.
So, why the little voyage into basic finance theory?
I think that when it comes to start-ups, we entrepreneurs get carried away with the possible returns without considering the associated risks.
Yes, it’s good to shoot for the stars – to pursue the astronomical returns that the most successful investors in start-ups have received.
However, it’s also prudent to consider the chances of the venture not working or working less successfully than anticipated. What is the risk? How probable is the success that I am aiming for?
Perhaps a less ambitious venture with a higher chance of success would be more appropriate.
Rather than spending three years investing everything you have into a new social media analytics platform, maybe you would be better off starting up a social media consultancy?
One has a much higher potential pay-off but also a lot more risk.
I’m not saying don’t be crazy brave. I’m not saying don’t try to do the amazing – to get rich and famous and end up on the cover of magazines no one reads any more.
What I am saying is to not only look at the potential returns of your new idea but to also quietly and dispassionately analyse the risks.
A soldier who storms a house full of the enemy is brave only if he realised that there might be enemy in the house in the first place.
Know the risks. Then decide if you want to go forward. That is the real mark of bravery (and intelligence).