Professor Marshall Ketchum eyed the young graduate student. His colleague, Professor Marschak, former director of the Cowles Commission for Research in Economics, had directed the student to get a reading list from the learned academic. That student would go on to win the Nobel Prize. And it was all because of one of the books on that list, a book written by John Burr Williams.
When you talk to people about what it takes to be an “entrepreneur,” most people will say you need to be a risk taker.
When you talk to people about what it means to be a “risk taker,” most people will begin describing daredevils and gamblers.
In both cases, these answers are at best incomplete if not totally incorrect.
Risk taking is fundamental to sound investing. Without risk, there could be no return. It’s actually as simple as the law of supply and demand.
Here’s an example: Would you run across a busy 7-lane interstate for a dollar? Probably not. Would you take that chance if the payoff was a million dollars? Many would.
If the reward is too small, it’s not worth the risk required to obtain it. If the reward is large enough, you’d be willing to take on more risk to obtain it.
This is called the “Risk-Return Tradeoff” and it forms the basis of “Portfolio Theory”—the bedrock of modern investing. Nobel Prize winner Harry Markowitz is credited with first articulating this. According to Markowitz, “The basic concepts of Portfolio Theory came to me one afternoon in the library while reading John Burr Williams’s Theory of Investment Value.”
Entrepreneurs make decisions just like stock investors. The only difference is entrepreneurs invest in their own businesses, while stock investors invest in other people’s companies.
Since risk and return are two peas in the same pod, you can’t define risk solely in terms of its daredevil persona or its relevance to gambling.
Likewise, an entrepreneur is not necessarily a risk taker. Successful entrepreneurs know how to manage risk.
Here’s an example.
Take a fair penny. If you flip it, there’s an equal chance it will land on heads or tails. If it costs you a dollar to flip and you get eighty cents back if you can correctly guess whether it would land on heads or tails, would you take that bet?
No, because even if you guess correctly, you’re still out twenty cents.
What if you could win a dollar for guessing correctly? Would you play?
This is a trickier question. On the face of it, it sounds like you wouldn’t care one way or another because if you win, all you’ll get back is your original dollar.
But you should care. And you should always say “No!” to this game.
Why? Because your chance of winning is only 50%. That means, on average, you’ll only win fifty cents for every dollar you pay.
At what point does it make sense to play the game? Well, if your average payoff is only half what the winning reward is, and you want to, on average, recoup your dollar investment, that reward would have to be a minimum of two dollars. That’s because your average payoff with a two-dollar reward is half that reward, or one dollar.
Risk managers always pay attention to the odds of obtaining their payoff. Entrepreneurs, therefore, focus on maximizing their chances of getting the reward by minimizing the risks involved. In this way, winning entrepreneurs can better be described as “risk avoiders” rather than “risk takers.”
Now, don’t think there’s no risk involved. Any new venture, whether business or personal, entails unknowns. And unknowns mean there’s risk. Entrepreneurs embrace this risk, not risk in general, but a special kind of risk. Researcher Sally Caird calls it “calculated risk taking” and describes it this way:
“Calculated risk-taking is operationally defined as the ability to deal with incomplete information and act on a risky option, that requires skill, to actualize challenging but realistic goals.”
Academics aside, experienced entrepreneurs realize success only comes when taking a leap of faith. “If you don’t take chances, you won’t move ahead,” says Vincent Zurzolo, COO of Metropoliscomics.com and ComicConnect.com in New York City. “Every entrepreneur has to take chances to get the deals they want, to drive their business forward, and reach a place where they can be fulfilled.”
The opportunity to practice calculated risk taking doesn’t arise in most established businesses (unless you’re the CEO, and, even then, sometimes it’s better to play it safe). As a rule, therefore, a successful corporate career will not necessarily translate into a successful entrepreneurial experience. In fact, these paths may require contradictory traits.
“Change doesn’t exist without calculated risk,” says Thyme Sullivan, Co-Founder & CEO of TOP the organic project in Duxbury, Massachusetts. “My corporate background did not encourage risk, it was in fact the opposite. If you stayed in line, did things as they have always been done, it was safe, regardless of the outcome. To be an effective entrepreneur you have to untrain yourself to do what everyone else is doing. We were taught in school and corporate America to stay in line and follow the playbook. You have to fight that muscle memory and follow your instinct, what you know to be a calculated risk. Once you exercise this freedom of thought and action it just feels right, it’s resonance.”
Before assessing yourself, you might benefit from studying the people around you. Do they aspire to conformity, or are they constantly searching for the coming thing? And, if the latter, do they ride willy-nilly down the rabbit hole of unconstrained thought, or do they contemplate what the path of least resistance looks like? Seeing how others think and do things may help you understand the mental exercises you’ll have to practice in order to make calculated risk-taking second nature.
“I always find it fascinating that some people remain uncomfortably comfortable—perhaps masking their unfulfillment with various things; whereas, some of us (especially entrepreneurs) are willing to get uncomfortable—in some ways, we live there,” says Mollie Krengel, Founder of Wild Bum in Minneapolis. “It’s like building a muscle. It’s not easy and it takes practice, but we can actually start to enjoy it. Calculated risks begin to feel good and when they don’t work, we adapt and make changes. I cannot imagine a life where I am not trying new things and stretching myself.”
Have you ever heard of “paralysis by analysis”? This occurs when you analyze something far beyond the usefulness of additional analysis. It gets to the point where you fail to make a decision because you (falsely) feel more analysis is needed. Many have missed their “Golden Ring” opportunity because they have been too afraid to make a decision when they’re in the Red Zone. To them, taking any “premature” action would be akin to betting on the ponies at the local race track.
Caird warns that those who score low on the “calculated risk-taking” scale tend to have “a cautious nature; a painstaking approach to decision-making; and a preference for working with certainty.” Successful entrepreneurs use calculated risk-taking to overcome this phobia.
“Instead of being paralyzed by fear, you make necessary calculations and then decide if you should launch,” says David Lowe, Co-Founder/Chief Marketing Officer at Guardia Medical in San Diego. “People mistake this as gambling which is totally incorrect. You are taking a calculated risk. Being a risk taker gives you big returns if you succeed. It takes years to develop this part of the brain because that part of your body is trying to protect you and tell you to play it safe. Entrepreneurship is as much about mastering the mental side of business as it is the physical.”
How precisely do you go about calculating your risks? First, it starts with you knowing yourself. Does the unknown take you out of your comfort zone? If you don’t think it does, then you’ll never know how to manage that risk. Everyone has a comfort zone. You better find out what yours is before moving on.
“Everyone has a certain level of risk tolerance; some quite high, some quite low,” says Julie Bee, President and Founder of BeeSmart Social Media and Lead From Anywhere in Charlotte, North Carolina. “Starting and operating a business requires at least a moderate level of risk tolerance. It’s important to first know where your own risk tolerance falls. Then you have to get good at calculating the potential risk of major decisions”
Once you determine your safe zone, you can assess the various risks associated with your burgeoning idea. This is where the fun part begins.
“My rule of thumb is to think through the worst thing that could happen and the best thing that could happen, from any risk you take,” says Bee. “It’s likely the end result will fall somewhere in between those two things. If you can tolerate the worst thing that could happen, and the risk has a potential great benefit to your company, then the risk is probably worth taking. That’s the process I go through to calculate risk and make decisions.”
What might you see in yourself that would indicate you are a calculated risk-taker? According to Caird, you score high if you’ve demonstrated “the ability to judge that a risk is worth taking when the consequences of failure do not outweigh the incentive value of success; the ability to make decisions in uncertain conditions; and the tendency to make decisions without exhaustively gathering information.”
So, are entrepreneurs risk-takers? Not in the way you think. Sure, they’re not afraid of risk, but they seek to diminish it by managing it.
“Entrepreneurs are not inherent risk takers, but rather calculated risk takers,” says Chin Beckmann, CEO & Co-Founder of DSP Concepts in Santa Clara, California. “It is important to first and foremost understand the problems you are solving; it takes insight and experience to find new, sustainable and effective solutions. Simply coming up with a random idea and using other people’s money recklessly contributes to 90% of failed start-ups.”
Many think the secret to becoming a successful entrepreneur lies in the unique idea you discover. While this can help, many unique ideas fall flat upon execution.
Why? Because of a failure to manage risk properly.