“Risk is the act of not knowing or not being fully conscious of when you are taking it.”
The following is not meant to be an exhaustive or bullet proof way of reducing risk, but more as an approach to identifying and beginning to quantify your downside (and upside) when making investments, including those in your own business.
Identifying the Categories of Risk
Market Risk- equities and bonds, both U.S. and global- Interest Rate Risk- when your investment is sensitive to movements in interest rates, you will know it.
- Currency Risk- Having all your investments in one currency or in others either directly or by way of revenues that come from foreign countries
- Diversification Risk- It comes in two forms: one type is not being diversified enough (i.e., concentration risk), whereas the other is being ‘too diversified.’ Concentration to the point whereby if an investment goes south or to zero, it affects your net worth, lifestyle or even your mental well-being. This is a personal judgment. Over diversification amounts to investing like an index fund and not fully understanding the positions you own- in other words, being spread too thin and /or not understanding how they correlate with each other.
- Commodity risk- is your investment affected by swings in commodity prices such as energy (oil, gas & coal), precious metals (gold, silver, platinum and palladium), industrial metals (copper, zinc, etc.), agriculture (corn, soybeans, cotton, cocoa,etc.)
- Hedging- both the risk of hedging and the risk of not hedging; understanding your costs and the likely outcomes of each decision.
- Risk of fraud- can result from lack of due diligence and not doing background checks. However, if someone or a certain company wants to defraud investor,s and it is a coordinated, deliberate effort, due diligence may not be enough to detect it in advance.
- IP or patent infringement risk
- Volatility risk
- Opportunity Cost risk- being in too much cash.
- Liquidity risk
- Time Horizon risk
- Technology risk- can your business become obsolete or significantly impacted by new, unforeseen technology?
- Competitive risk
- Risk Management risk- cutting your losses vs. letting your winners run
- Leverage risk
- Execution risk
- Deposit risk- where you hold your money, whether it be at a bank, brokerage firm or prime broker
- Collectibles risk (wine, art, precious stamps, antique cars, etc.)
- Fund risk versus investing directly- they are completely different.
- Key man risk- is the company dependent on one or two key people, and is the success of the business conditional on them being involved? What if they leave?
- Act of nature risk- do they have back up or contingency plans in place in case the company and physical locations are destroyed by hurricane, tornado, earthquake, fire, or explosion.
- Insurance risk
Ways of Reducing Risk in private investments
One cannot eliminate or prevent risk 100% of the time, but there are a myriad of ways to reduce it:
- Having legal counsel, your accountant or a trusted adviser review documents (and the investment itself where appropriate).
- Solicit the advice of ‘experts’ in the industry or in the field you are making an investment. Consider paying someone for due diligence, particularly in the areas of IP- patents, trademarks, etc…
- Does the fund or company have a track record? Trust but verify, and speak to people, employees, vendors and suppliers about the company and others in the industry.
- Do the principals of the company or board members have investments in the company or fund? If so, how much? (again, trust but verify). If not, why not? Keep in mind there is a difference between ‘sweat equity’ and an investment in cash versus loans.
- Understand your time horizons in terms of liquidity or an exit strategy (sale of the company versus an IPO with lock-ups).
- Background checks- your own and consider paying a professional firm to help you, particularly in a foreign country.
- Qualify the board of directors, particularly the ‘outside’ directors.
- Determine whether or not a company or fund is raising enough money, how long it will last them, and if/when they will have to raise money in the future.
- Come up with an exhaustive list of how the company could fail or not achieve its goals, including revenue or earnings targets. Understand cash flows, and follow the money. Understand where and when break-even might occur.
- Have a full understanding of the competitive landscape, including past, present and future competition.
- Insist on key man insurance if the company is dependent upon one (or two) key people.
- Make sure the company has all relevant insurance in place, and ask for a list as well as proof that they are current.
- Ask for permission to speak with past investors in order to find out independently if the company is executing on their plan and are they walking their talk. If there are no past investors, talk to the current ones. Make certain you get a cross section of those who are dissatisfied, as the tendency will be to direct you towards investors who are satisfied.
