How Knowing Your Risk Profile Can Help You Build a Stronger Company

A comprehensive framework to assess reserves and build up resilience for your entrepreneurial journey

Shall I leave my company and start my own fund? Where do I get the funding? How many reserves do I need? What are the startup costs?

In my fund management community, I hear these questions often.

Entrepreneurs see different pros and cons in starting a business; there is no perfect answer to the question. It depends on the timing, their resources and ability, and crucially the passion to create something impactful.

To help answer these questions, I borrow something I learn from the Wealth Management industry.

It is about?risk profiling, a thorough framework that evaluates the client’s?risk tolerance, risk needs or objectives, and risk-taking capacity?before presenting the investment choices that best match their risk profile and objective under expected market conditions. These choices slant from conservative, moderate, to aggressive reflecting the risk attitude, capacity, and goals of the clients.

Each of the 3 dimensions of risks serves a different purpose and needs to be evaluated separately. Often, our answers for the 3 types of risks show inconsistency. For example, a young but risk-averse investor has a long investment horizon. Putting her into a growth portfolio will be useless because the moment the loss racks up, the young investor will cry “sell”.

Consider risk tolerance first.

Similarly, even if a high-risk tolerance person wants to take risks and desires a good return but her investment horizon is short and she has no spare capacity, she cannot afford to take great risks.

The risk-taking capacity sets the upper bound to the riskiness of the portfolio.

In these cases, a deeper discussion with the financial advisor and adjustments to their goals and expectations are necessary.

For entrepreneurs, a deeper look at our mindset, needs, and reserves first will better prepare us for the entrepreneurial journey or reveal the plunge is not suitable.

1. Assessing Risk Tolerance

Risk tolerance evaluates a person’s willingness and attitude towards taking risks. It measures someone’s behavioural loss tolerance when facing a risk of loss for the potential of gains. In fact, risk tolerance considers risk perception, composure, tolerance, and investing experiences.

I like?FinaMetrica’s psychometric risk tolerance approach ?for investors. You can review their detailed?questionnaires ?(10 or 25 questions in a hard copy).

For example, what does taking financial risk mean to you? Danger, uncertainty, opportunity, or thrill? When faced with a financial decision, are you more concerned about the possible gains or losses? Will you borrow to take advantage of a potentially substantial investment opportunity? What percentage loss of your investments can you tolerate before your stomach churns badly?

Similarly, for founders, does entrepreneurship look dangerous or thrilling to me? Am I concerned more about gains or losses? How will I fund my startup — from savings, borrowings, or equity-raising? Can I sacrifice some comfort and stability for future gains, bearing in mind my company can completely fail?

2. Establishing Risk Needs (Objectives)

Wealth professionals ask their clients a series of questions to establish their investment needs and goals. These include their investment horizon (short, medium, long, ultra-long), required rate of returns, cashflow needs/contribution on an annual basis, investment objective (is it capital preservation, income, accumulation, or growth, etc.), and how well they can tolerate failure in realizing their financial goals.

The questions entrepreneurs can pose to themselves include: am I doing this for a quick gain or in it for the long haul? Is my objective about impact, financial, fame, or others? Do I want to make this a unicorn? How much burn rate can the business sustain per year (from the minimum viable to the best case)? How well can I tolerate business failure? Is my project timing right? Am I creating a market need or is there an existing market demand for it?

3. Compare Risk Tolerance and Objective with Risk-Taking Capacity

High risk tolerance and risk need scores that show a person wants and needs to take risks do not necessarily mean they can! Even if they remain composed in the face of risk, do they really need to take it?

Wealth professionals consider the clients’ investment horizon, outside income/net worth , and other liabilities to establish their risk-taking ability: the losses they can bear without adversely impacting their current living standard.

As an entrepreneur, evaluate carefully our network and personal resources to fund the business before our product can make money.

Porter Gale in her book “Your Network is Your Networth ” suggested we already have what it takes to build our business.?Your network is like money in the bank . However, we should be willing to ask for favours and be strategic about building our network.

The article “Solutions to Women’s Advancement ” brought up an interesting point: males tend to network for transactional purposes while females network for relationship-building and social reasons. A strategic relationship helps us further our career aspirations and long-term business goals; a social relationship, well, is nice but may not grow the business.

This?Harvard study ?mentioned successful female professional networks are efficient, nimble, boundary-spanning, and energy-balanced.

Summing Up

Once we evaluate our risk tolerance behaviour, needs, and capacity separately and comprehensively, we can have a better assessment of the risk and return tradeoff of running our own business versus working for others. Our expectations of success may become more realistic, and we can align better our resources to grow the company.

Rather than just looking at potential gains or losses of our business, a better understanding of our risk profile will help us stay focused on our long-term goals and values. We won’t overreact to short-term crises or become addicted to success and can pace, adapt, or pivot accordingly. We can then map our risk profile to our best-suited “portfolio” or project to fulfill our goals and purposes.

When the environment becomes more uncertain, an entrepreneur has a better chance of standing out. After all, giant companies such as The Hyatt Hotels, HP, Microsoft, Square, Uber, and Airbnb?all started during or because of a recession .

What determines our subsequent actions is our attitude towards failure.

“Do not judge me by my successes, judge me by how many times I fell down and got back up again.” -Nelson Mandela

If you are interested to follow my journey in building a digital investment solution , please follow us?at Lumen at https://www.lumenglobalinv.com/ .

Reference:

Hubble, A., Grable, J.E., Dannhauser, B. (2020). Investment Risk Profiling: A Guide for Financial Advisors,?CFA Institute.?https://www.cfainstitute.org/en/research/industry-research/investment-risk-profiling

The article was originally published by DataDrivenInvestor on Medium .