Risk taking

Bankers and financial professionals try to measure risk and returns using all kinds of academic and empirical bases - NPVs, IRRs, weighted average cost of capital, etc.


I introduce to you a new way of looking at risk: How much are you willing to lose?


Say you pay $10 to flip a coin. Heads: you get double the amount ($20), Tails: you walk away empty-handed. Now consider that it'll now cost you $1,000,000 to do this. Would you still take the chance?


Mathematical models involving the calculation of risk unfortunately omits the element of human emotion. For many investment decisions in Asia and other emerging markets, emotion is often a huge part of what drives the deal. This is probably the single biggest reason why your complex DCF and bullet-proof-calculated discount rates don't weigh very much in this part of the world.


Mispriced deals exist all the time because the stakeholders can't accept what they possibly could stand to lose.


Consider a scenario in which a business owner will never relinquish a partial stake in the company to an incoming buyer who has plans to break up the assets and change its corporate direction. Or a seller signing off on an under-valued transaction just to close the deal because he/she can't live with the possibility that there might not be another better offer on the table.


All risk models break down when you have everything (or nothing) to lose. Managing it gets easier when you are more diversified and don't go to the negotiating table with an all-or-nothing mentality.


The next time you are presented with an opportunity that offers a certain rate of return, think: what are you prepared to lose?

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