Understand risk appetite October 4, 2011

A ship is safe in harbor, but that’s not what ships are for.

The Owner of a business takes significant risk (financial, legal, and ethical). An employee can do many things to put the company in a risky circumstance, at no risk to the employee themselves.

For the risk the Owner takes, they demand commensurate return. The Owner could invest their money in many things – property, the share market, .com start-ups, a bank, gold, llamas… or a business. So the Owner must ask themselves, “For the risk I am exposed to, is this the best return for my money and efforts?”

Putting money in a bank is low risk and safe – banks are insured, so you’re guaranteed to get your money back. But, that money won’t “work” very hard for you – 6% return at the most. That means, you put $100 in a bank account, at 4% interest, in 12 months you’d get $104 back. A free $4 is nice, but not amazing, but you’re also not risking anything: low risk, low return.

You could invest your money in “blue chip” shares (reliable companies who are very likely to increase their value in the future) and get 6%. Or, you could invest in a government (through government bonds, essentially loaning the government money) at 3%, where you’ll be paid $3 a year for the term of the bond, but have your money locked away for 5 years before you can get that $100 back.

All of these are low risk, low effort and low return.

An Owner invests in a company with no guarantee of return, other than their own skills to manage that company and their belief in the skills of the people they have hired – that’s high risk. The Owner “backs themself”, trusts themselves to do well, and expects a return of 20%, or more (some businesses might be up to 40%). You invest $100 of your own money, and you get back $140 a year later. Higher risk (increased chance of failure, losing all $140, your house, reputation, friends), and higher return.

As an employee, you have extremely low risk in not being paid each fortnight, thus there is extremely low risk to you. However, a company is not guaranteed to get income each week, thus there is a high risk to the Owner – they still have to pay their employees (and all the other expenses)! Higher risk, higher return.

So, why not start your own business? People have different risk “appetites”. Many people choose not to risk much (said to be “risk averse”) and work for someone else. Low risk and lower return… but safe and reliable, and allows time for other pursuits.

Others run a business. Others bet on the ponies at the local off-track.

A business owner reduces (or, “mitigates”) their risk by having, for example, processes and systems around training sessions and mentoring of staff, audit systems to retroactively assess works, regular research into relevant legal areas, and budgets in place and followed (this is not an exhaustive list).

Professional people understand risk appetites and align their work practices as to match with the company; nor playing too safe as to restrict the business and not too “fast and loose”, risking loss, damage, safety, or profitability.

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