So you want to start a new venture, a new investment, and you're afraid of losing money? That's good! Every venture has a cost and knowing how to quantify the risk and reward is a good way to determine how you should be investing and how to set yourself up for long-term success. This article contains the basics of what you need to know to assess risk and allocate capital.
Those who have taken my Fundamentals of Passive Real Estate investing course (https://bit.ly/2RFURAU) know that one of my favorite topics is risk quantification and management.
What is Risk Quantification?
Risk quantification means assessing the various risks in a deal or venture, and determining the likelihood that the event will occur and the magnitude of loss that such an event would cause.
Probability of Loss vs Pain of Loss
For example, even though if a car were to drive through a red light a pedestrian in the crosswalk would probably not survive (high magnitude), the odds of such an event happening are so small (low likelihood of occurrence) that no one hesitates to cross at a red light.
If someone buys $1000 worth of stocks, the magnitude of the potential loss is 100%. The probability of such a loss depends on the stocks one is purchasing.
If someone were to purchase a property with a loan and invest $100,000 of their own funds the magnitude of the loss will be $100,000 plus the full amount of the loan, unless the loan is one that does not carry personal liability.
If one purchases an investment property under their own name and fail to take out an insurance policy, the potential loss can be infinite (not in reality, but theoretically speaking). How so? If someone were to trip and fall on their property, they can be held personally liable to pay for pain and damages.
It is always important to start-off by understanding what is "on the line" and only then can one decide what steps and costs make sense to limit them.
Another factor that is important to discuss when talking about risk is the risk/reward ratio. Understanding the potential upside of an investment is not only important because we want more if we risk more; it's also good money management.
Imagine that you are a stock trader, and you enter positions that have a 50% change of doubling and a 50% chance of being a total loss. If your odds of winning your trades are only 50%, on average, you won't make any money.
There are two ways to make your trading business profitable:
1) You can win more than 50% of your trades.
2) You can win bigger.
Which do you think is harder?
If you said "win more trades", you're right!
By simply entering trades with more upside potential, you can still lose half your trades and still be very successful.
An extreme example of this are VC funds. Venture Capital funds invest In startup companies that have potential to be worth billions. Most companies fail. A few succeed, wildly. The winners more than make up for the losers, even though the losers outnumber the winners by more than two to one.
This is why knowing your risk/reward ratio and sticking to it is critical to a long term plan.
How does this apply to real estate?
A real estate deal is not nearly as neat and clean as a stock or option trade. But one should make sure to understand the risks of a deal and make sure the payoff is commensurate. You shouldn't make just 14% IRR on a ground-up construction deal. You should diversify enough to benefit from having a smart risk/reward ratio.
Note: that the higher reward potential of a higher risk deal means that even if some of the risk factors actualize and hurt the return, the investment has a cushion to underperform expectations and still be profitable.
To sum it up, always determine the maximum possible loss and maximum gain. Then, try to figure out the odds of success. If you are constantly investing in positions where the gain is greater than the loss and the odds of success are greater than that of failure, you are almost guaranteed to be very successful in the long-term.
Know thy risks. Know thy rewards.