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Risk Assessment, Strategy & Its Implications On The World We Live In, Especially In The Context Of Building Companies

Risk Assessment, Strategy & Its Implications On The World We Live In, Especially In The Context Of Building Companies


Risk assessment problems can be analyzed quite seriously in a form that reduces them to one dimension: the amount of capital to allocate to a particular risky bet.

I happen to be quite familiar with the Kelly criterion, as I’ve discovered it myself while working on my thesis. Imagine you have unlimited access to a casino that offers a game of roulette in your favor. You bet on red or on black, if you guessed right you receive 2x your bet, if you guessed wrong your bet is gone, but a zero is counted in your favor, and you still get 2x your bet.

Clearly, this game is skewed in your favor in the long run, and every mathematically inclined person would eventually become a trillionaire if they play it long enough. In order to win at this game though the trick is to figure out how much to bet on each round. (There’s not much to analyze in this simplified setting, after all!)

It is relatively easy to show that betting above a certain fraction of your capital would result in inevitably losing all your money in the long run.

Yet, at the same time, betting below some optimal fraction would result in your capital not growing quickly enough.

An interesting observation about human nature is that while people are generally risk-averse, we tend to bet far more than an optimum share or our capital in each bet. I encourage you to think of how much you would bet on such a roulette.

If that’s tricky to visualize, an English Wikipedia page about the Kelly criterion [1] offers the analysis of a simplified problem where the roulette is replaced by an unfair 60/40 coin. I was not surprised that a large fraction of humans, who were part of a real-life experiment, went bust. Even though the game is clearly rigged in their favor, and the rules are announced beforehand.

The TL;DR of the above is that even for the opportunities that are clearly EV-positive, betting more than a certain, reasonable, fraction of your capital on them can and will backfire. Not putting all the eggs into one basket is not just conventional wisdom; it’s investment advice, backed up by science.

The above, in fact, yields quite a few conclusions:

Firstly, the mathematical one. Perversely, and seemingly contradictory, it implies that, under certain conditions, acting against the best interest of a particular company and/or its shareholders and employees may well be beneficial for the larger-scale entity that has a diversified portfolio of such companies.

Moreover, contradictory as it sounds, it would often be the fiduciary duty of the investor’s representative to advise this company to deliberately act against its best interest in the long run. 

Simply put, if money is cheap, which happens quite often on a historic scale. Then, a clever investor would be wise to over-fund several diversified companies. Selecting them for, and encouraging them to take far more risk than each individual company would be better off taking.

More dangerous than optimal for each particular company. Fulrthermore, more likely to ruin any particular company. More profitable for the investor in the long run. All of the above, however controversial, becomes backed up by rather solid (and rather trivial) math.

Now, the practical conclusion. About how to build and grow companies. It follows directly from the above that:
  • If you are of the ambitious, risk-seeking, “fail fast, fail better” type, and if your identity is comfortable with seemingly unrealistic projections — go for venture funding. Be sure to present the above as your strong sides, and, as long as you check all the boxes, you’ll likely find people with excess money who are more than willing to [over]fund you — as long as you are willing to play this “I’m risk-seeking” card strongly, and stay focused on the goal, in the “do one thing and do it well” fashion.
  • At the same time, if you care about your own well-being. About how you spend your days. And about your peers / team / employees, on a personal level. Then chances are that you are better off bootstrapping or self-funding. Remain risk-averse, don’t gamble, and, if in doubt, don’t make dangerous moves. Start slow, and build it up gradually, staying on solid grounds all the time. Attract like-minded people! By honestly selling them the vision that your goal is to build and grow a company that intends to last for a very long time, and that, unlike in over-funded companies, you would be acting in the best interest of yourself, the company, and whoever is part of it.
As long as the investment climate is warm. And it is warm quite often, even though for the past two years and, likely, for another one-and-a-half-ish years, it might remain cold. Your expected value is likely higher if you follow the VC route.

Unironically, the above makes me rethink my views on how some overfunded companies that I was part of were run. Back then, I believed:

  • That I could convince the founders that what they plan to do would act against the interests of the company,• That they would listen to me, and• That they would alter the course accordingly, and thank me afterwards.
However, now, thinking of it further, pretty much the opposite is likely true:
  • Those founders were of the risk-seeking types, otherwise they would not be founders of VC-backed companies,• Those founders became openly encouraged to take excess risks,
  • This is healthy in the venture-backed climate, and most, if not all, VC-backed companies should and would act like that,
  • It’s a feature, not a bug, and trying to “convince them otherwise” both was and remains foolish.

Lesson learned TL;DR: in the realm of the venture-backed industry, think of investors’ interest, not of the company interest, when assessing the optimal degree of risk. This optimal degree of risk would likely look insanely high from the standpoint of an individual company, which is, in fact, healthy. Cope with this, accept the gamble, and play along to make it happen; or play elsewhere if accepting this approach goes against your personal preferences in life choices.

Ultimately, for mental health and for best self-actualization. It becomes important to do what you love and to love what you do. Thus, realistically, your best strategy likely is to optimize not for EV, but for whatever strategy fits your personality best.

Paraphrasing how another friend of mine concisely put it:

Yes, it pays off to invest into well-being and into moving slowly. And the best time to do it is after some of your more risky bets have paid off. Can’t agree more.

Risk Assessment, Strategy & Its Implications On The World We Live In, Especially In The Context Of Building Companies


Physics Nobel Prize Winner MIT Prof Frank Wilczek