Whether you realize it or not, chances are you believe in the risk-reward trade-off. In its most basic form, it means the lower the risk, the lower the potential returns. And the higher the risk, the higher the potential returns.
The basic idea sounds perfectly logical. You have to take on extra risk to get a higher return.
It’s a cornerstone of financial economics. The vast majority of Wall Street thinks in terms of the risk-reward trade-off. And the concept has been repeated so often that people have stopped questioning it. And that’s a big problem.
The risk-rewards trade-off makes sense when it’s applied to an entire portfolio. Risky investments along with conservative investments tend to balance a portfolio’s performance.
But it doesn’t hold when applied to single investment decisions or opportunities. And it can stop you from making investments that hold the most promise.
Here’s part of Investopedia’s explanation of the risk-reward trade-off (emphasis mine):
According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.
If true… this is incredibly problematic for startup investors. It demands a huge risk appetite. Without one, you’re condemned to chase smaller returns. Because the only way to capture needle-moving gains is by accepting enormous risk. The risk-reward trade-off implies that the startup investing pool is full of danger — jump in at your own peril.
If true… the best startup investments I’ve ever made would never have happened. And I’d have to throw away my entire startup investing playbook.
But the reality of startup investing is much more nuanced. The risk-reward ratio varies from company to company.
Once you understand this simple fact, your investing goal becomes very clear. Invest in low risk and high reward startups. And let me assure you that combination does exist. There is indeed such a thing as a low risk/high reward startup. By shifting your perspective on risk and reward, you become better able to capture huge returns on your startup investments.
Now that’s great news. But let me temper your excitement just a bit. These companies don’t grow on trees. The challenge for every investor is how to identify them. Again, they’re out there — I can’t say this often enough! But you have to have something like X-ray vision to find them.
So, that’s what I’m going to do. I’m going to give you X-ray vision. It took me years to develop my X-ray vision… a way to see startups and immediately know they have this unusual combination of low risk and high reward. Then again, I was on my own. You can start developing yours right away simply by following the rules below.
The key is understanding which factors contribute to risk (or lack of risk) and which contribute to reward (or lack of reward).
Here are the five critical factors that determine risk and reward:
- Founders. I list them first for a reason. Exceptional founders — more than any other single factor — lower risk significantly. They can turn mediocre technology or products into a company that has staying power. Through sheer competence alone, their startups avoid worst-case scenarios. The opposite is true as well — less than competent founders can turn the best product or technology into an outright failure.
- Big explosive markets. This factor is often confused with the Wall Street mantra, “A rising tide floats all ships.” Investors take that to mean even poor companies flourish in fast-growing markets. But that’s not quite true. Those so-called “weak” companies (that are seen benefiting from the rising tide) were already doing a lot to grow and thrive in a competitive market. The far bigger impact of rapidly expanding markets is the upside they provide to companies that can dramatically grow their customers and sales year after year after year. Big markets produce big companies.
- Early revenue growth. One of the most exciting early developments for a startup is when it begins to generate revenue. Many investors mistake this for an early sign of upside. But that’s not right. Early stage revenue growth is much more about taking risk off the table than upside. Founders can talk all they want about building a needed product. But when products enter the market and actually generate revenue, that means people are buying the product. No matter how much research they do, companies never know for sure whether a product will sell until it actually happens. So early sales take that risk off the table. Early revenue also resets expectations. From concerns of “can the product sell,” the company (and investors) can now turn their attention to upside. How fast can sales expand? Which leads to our next factor.
- Scaling. There’s much less confusion about scaling so I’ll keep it brief. It’s all about upside and going big — selling on a massive scale while keeping costs at reasonable levels. Certain technologies, products and business models are easier to scale than others. As a general rule (for example), software-based startups are better able to scale than hardware startups.
- Moat/Defensibility. Companies that can fend off competitors — or don’t have serious competitors — are at less risk of failure. What’s more, it makes everything else easier, including growth. Some would say especially growth. The startup won’t have to share the market with a dozen other companies. Its ability to capture customers is less constrained. It has a much cleaner path to future growth. This is a hybrid factor, as much about risk as it is about upside.
Some companies make good investments because they’ve done a good job of reducing risk. Other startups because they’re able to enhance upside. And the best companies? Well, they do both.
Next week, I’ll give you examples of startups that fit into each of those categories.