Risky Business
Sometimes the seemingly most complex problems can be analyzed fairly simply by applying some simple statistics and a little guesswork. Since this blog is about personal finance I’ll use a financial example, but the process can be applied to many everyday decisions. (I recently decided the most cost effective periodontal treatment I should choose based on this kind of analysis – really!)
Preparing to Jump
So, let’s take a look at purchasing stock in a company you’re familiar with for which you can make some educated guesses about its future. The trick is to identify as accurately as possible the areas of risk the company might encounter. Examples could include market risk, political risk, management risk and capitalization risk. You can choose as many areas of risk as you like, but 4 or 5 will typically get the answers you’re looking for.
In our hypothetical example, you live next door to Fuzzy Fungus, Inc (FFI) and know some of the management. FFI has been around for 25 years, growing slowly, but you hear they’re about to introduce a brand new product. You want in.
Let’s look at some risk factors.
- Senior management are in their mid-50’s and have been running the show for about 10 years – risk is very low, say 5% chance of failure in the next two years.
- FFI is able to raise capital fairly easily, but with the tough lending environment risk of not being to raise money is a little higher than usual, but still only 10%
- They’re depending on a new product to bump revenues, but if it tanks, the revenues could go the other way. This may be the biggest risk, so we’ll guess it’s around 25%.
- And lastly, this isn’t about guns, cars, oil or healthcare, so the current political climate “shouldn’t” have too much impact, but still let’s say it’s still around 5%.
Now, how do we calculate overall risk and what does it mean? The answer we get will be a pretty general one, but essentially, we will know if the new product introduction will have a large positive effect on the stock price, given this risk factors we’ve considered. The calculation is easy. Simply multiple the chances of success for all of the risk factors to get an overall chance of success. (The chance of success is 1- % chance of failure, expressed as a decimal.) And the answer –
Management X Capital X Market X Political = Overall Chance of Success
(1-.05) X (1-.10) X (1 – .25) X (1 – .05) = 61%
Based on this answer, I would probably continue my research into the company. If the answer was 40% or less, I would almost certainly pass.
Of course, there are a myriad of other factors you should consider before investing in stocks, but this is a quick way of deciding whether it’s worth a further investment of time, effort. and, most importantly, money.
