Danger and opportunity; risk and return

Submitted by douglas on Sun, 20/07/2008 - 3:17am

Dangerous point or turning point?

weiji.gif This Chinese character (pronounced “Wei Ji”), like many Chinese characters, is composed of two individual characters, each one with a different meaning. The first character means “danger” and the second means “opportunity.” When combined, they mean “crisis”.

The word “crisis” is commonly associated with “a situation that has reached an extremely difficult or dangerous point” with special attention paid to the element of danger in the situation. However, a key sense of the word crisis is that it refers to a “turning point for better or worse.” In this way, “Wei Ji” encapsulates the essence of venture capital investment. Further, I believe that these two subtly different definitions of the meaning of this word can help to explain the fundamental reasons for investing in venture capital.
 

Risk and return

To better understand the relationship between “Wei Ji” and the essence of venture capital investment, it will help to substitute “risk” for “danger” and “return” for “opportunity” to relate the concepts more closely to finance.  Investors must deal with risk and return on a daily basis; these concepts may become so familiar that we take them for granted.  This familiarity can become dangerous as making accurate assessments of risk-adjusted returns is critical to success in venture capital investing.  The individual’s propensity to take risk - their level of risk aversion or risk seeking behavior, can also play a significant role in decision-making.  In situations like these, it can be useful to take a step back and look afresh at risk and return so as to make sure we are seeing them clearly.  Answering some basic questions about risk and return can lead to a greater insight into this fundamental area of investment decision-making.  These questions are: 

  1. What is risk?
  2. What is the relationship between risk and return?
  3. Why does this relationship hold true?

What is risk?

One common definition of risk is “probability of loss.”  This type of understanding of risk can be useful in the physical world, where the potential returns to many types of risk are heavily shifted toward the downside.  For example, the risk of loss through a serious head injury incurred by riding a motorcycle without a helmet so far outweighs whatever potential gains might accrue that it makes sense to analyze this risk just in terms of the probability of loss.  However, in the financial world, this type of common-sense analysis not only ceases to make sense, it is highly likely to lead to suboptimal investment decision-making.  In the financial world, “risk” is better understood as the variance of the potential returns from an investment.  An investment with a low variance of its potential returns would be considered a low-risk investment while an investment with a high variance of its potential returns would be considered a high-risk investment.  The key difference in defining risk as the probability of loss versus defining risk as the variance of potential returns is that a high variance of returns can create both high loss and high gain.  The common association of risk with loss treats only downside risk while ignoring upside risk.  In a world with only downside risk, all rational people would be risk averse.  In a world where there are both upside risk and downside risk, rational people can be risk averse, risk seeking or risk neutral. 

What is the relationship between risk and return?

riskreturn.gif Risk and return are highly positively correlated. This correlation is often expressed as “High risk/high return; low risk/low return. These two statements may seem to be perfectly parallel; in fact they are not parallel at all, but are making two very points about risk and return.

This difference can be clearly seen if we rephrase each statement in the form of an If/Then proposition. When we transform the statement “low risk/low return” in this way, it becomes “If I take low risk, I will receive low return,” which is essentially true. However, if we transform the statement “high risk/high return” in the same way, it becomes “If I take high risk, I will receive high return,” which is clearly not the case. This is not the case because of the nature of high risk, which means that the returns will have a high variance, so that we would need to transform this statement to say:  “If I take high risk, I may receive high return, low return or no return at all.”  However, a more meaningful transformation would be:  “If I want to receive high return; I must take high risk.”  This is true because as much as we might wish that there were, there are for all practical intents and purposes, no low risk/high return investments.   

Why are there no low risk/high return investments?

How many people have ever found coins in the street? Almost everyone. How many people have ever found a $100 bill in the street? 100_ncd_face.jpg

I have asked this question of several thousand people, and only one or two have ever found one (or the equivalent amount note in another currency).  Why is it that you are likely to have found coins in the street but you have not found a $100 bill?  At first you might think it is because people are very careful with their $100 bills and do not drop them in the street, but are careless with their coins.  This is true and the supply of $100 bills in the street is therefore extremely low.  But since some people have actually found these $100 bills, they do exist in the street from time to time, but chances are you still haven’t found them.  The reason that you haven’t found them is that on the rare occasions that they do appear on the street, someone else always finds them first.  Finding a $100 bill in the street is a low risk/high return opportunity.  Like all low-risk/high-return opportunities, if they do appear for a fleeting moment, they are immediately erased by market forces (in this case the market forces are people picking up the bills as soon as they appear).  

In an investment market, the mechanism would be more complicated but the end result would be the same.  Take for example, an investment in a particular company that was mis-priced so that the return on the investment was not correlated with the risk of the investment; the return was too high relative to the risk of the investment.  The result would be that investors would flood into this investment.  In an investment market, investors are selling capital and investees are buying capital.  The return that the company is paying to its investors is the cost of capital for the company and the price at which the investors are selling their capital.  If a company is paying too high a price for their capital (i.e. offering a return that is too high), many investors will be willing to sell them capital at that price.  The supply of investment capital for the company will increase.  Assuming that the company’s demand for capital does not increase at the same rate, the price that the company is willing to pay for their capital will decline, as this is a cost from the company’s perspective.  Lowering the price they are paying for capital means that from the investor perspective, the return on the investment will be decreasing.  This will continue until the investment’s return is correlated with its risk.  The forces of supply and demand act inexorably to enforce the correlation between risk and return.  Another low risk/high return investment will have disappeared. 

This correlation between risk and return and the consequences of this correlation are the fundamental driving forces behind venture capital.  Since chasing low-risk/high return opportunities is a losing proposition, investors seeking high returns must take high risk.  For almost all time horizons in the last 20 years, venture capital has been the highest returning asset class available to investors, outperforming the public equities markets by a wide margin.  Within the venture capital market itself, early stage venture capital investments which are more risky have consistently yielded higher returns than later stage venture capital. As long as the relationship between risk and return continues to be enforced by the laws of supply and demand, there will continue to be demand for venture capital investment by investors seeking the highest possible returns.

Category: 
Venture Capital

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