The Elements of Risk

Topic Progress:

Uncertainty is Not the Same Thing as Risk

What if I offered you the opportunity to play a game in which your odds of winning were just 1 in 1,000. Would you play? After all, the outcome is highly uncertain. Most people will say, “No, thanks.”

It’s a trick question, though. In truth, you don’t have enough information to make a good decision. The rational response is, “How much does it cost to play, and how much can I win?”

If the cost to play is just $0.10 per game, and the payoff for winning is $1,000, you would play this game all the time. After all, the cost of playing 1,000 games is just $100 (1,000 games x $0.10 per game = $100). The odds are, you’ll win $1,000 in every 1,000 tries, So, your expected profit for playing 1,000 games is $1,000 – $100 = $900.

Infinite Wealth
Even a game that offers low odds of winning can be very lucrative.

This is a game characterized by high uncertainty but low risk. In fact, it’s a money printing game. Keep playing, and you’ll generate infinite wealth.

The Elements of Risk

In simple – but useful – terms, risk is a function of three factors:

  • Uncertainty
  • Potential payoff
  • Skin in the game

Uncertainty describes the odds of receiving the potential payoff, and “skin in the game” is what you have to lose.

A banker, for instance, typically has a lot of skin in the game (the amount of their loan), but their potential payoff might be just 2% to 4% net interest per year. A $1 million loan, for instance, might yield net interest of $20,000 to $40,000 per year. Once bad loan can wipe out years’ worth of income. As a consequence, bankers can’t afford to underwrite much uncertainty at all.

Understanding Risk

Understanding risk from a variety of perspectives will help you make better choices about the right financing for your business. As we’ll explore in more depth later, pitching a lender on the (uncertain) growth potential of your business, for instance, might not only be a waste of time. It might be downright counterproductive.