Risk, Reward, and Leverage
Every decision carries a risk and reward. This is true for both professional and personal decisions.
We all try to take decisions with large reward and little risk. Usually we end up optimizing for short term rewards since we are notoriously bad at thinking long term.
Leverage (investing money, building software, having a team work for you) amplifies the outcome, higher reward but also higher risk.
The search for asymmetry
Investing is to find a potential reward (profits from a company) and add leverage to it (money).
The one thing to avoid is asymmetric risk. The risk of a larger downfall than upside in the investment. One example is seasonality. It means that a business sells strongly during one time of the year and less during another, think ice cream truck.
It’s an asymmetric risk since one rainy summer can evaporate the entire income of the ice cream truck but good weather will never triple the sales.
When buying companies this risk is multiplied (we are adding leverage). While the ice cream truck might lose their entire business after a bad summer, you stand to lose your entire investment (which is typically larger than the businesses’ annual income).
Find these risks before investing.
Find asymmetric reward
Finding asymmetric rewards drives value. In the context of buying companies people often think about synergies.
One example is Disney’s acquisition of Marvel. Sure, they took a risk by buying a huge company like Marvel. They were, however, uniquely positioned to have an asymmetric return. Each film produced by Marvel generated a much higher return in Disney infrastructure than the sales of the movie itself. For each movie sold Disney also sold a toy or a ticket to one of their theme parks.
Finding leverage and asymmetric reward is hard. It always looks different.
What I have found works is to read about how others have done it, in my case about other acquisitions. It helps you build a mental checklist of what to look for. Find similar opportunities in your field.
History doesn’t repeat itself but it often rhymes
Thank you for reading,