Risk and reward in the age of the COVID-19 pandemic by Harry Friedberg, partner, BX3
The concept of risk and reward is ingrained in all facets of life. Of a new product launch with an aggressive roll-out date, we’ll say “no risk, no reward.” At the baseball diamond, when the coach gives the sign to steal home to win the big game, we deem it “worth the risk.” It would be my guess, however, that we never really think deeply about the actual meaning behind these phrases. What exactly is risk-reward and how do we come to these conclusions?
In simple terms, we are making a calculated bet where outcomes can be ascertained and after analysis of all the possible outcomes relative to the goal or reward that can be achieved, we deem that it would be an appropriate measure to go forward with a plan, task, or investment.
In normal environments, one is able to make assessments of possible outcomes. This isn’t to say that there is certainty of these outcomes but rather, that there is a certainty to the possible uncertainties. Market data, experience, and the sound advice of professionals enables you to decide all of the possible outcomes, then assign a percentage of likelihood. Let’s use a new product introduction as an example. The percentages for likely outcomes may look like this:
Unprecedented product adoption with no modifications: 10 percent
Moderate success of product: 25 percent
Product requires substantial additional enhancements and expenditures: 10 percent
Market reception is mixed, not much added to incremental revenues: 28 percent
Market is yet undefined and product fails: 25 percent
Product fails, marring reputation of company and existing products: 2 percent
Monte Carlo Simulations
The best course of action in this case appears to be doing more market research and product development before deciding to roll out the new product—a course of action that may seem conservative, but one that is supported by the likelihood of the various outcomes. These calculations are known as Monte Carlo simulations. Consciously or unconsciously, all individuals, investors, and businesses make these calculations each and every day.
With the world grappling with unprecedented uncertainties, individuals, companies, and investors are now trying to figure how to factor in an ever-increasing array of possible outcomes. Ideas once thought of as absurd or impossible, are suddenly considered possible, if not very likely. In recent days, I have had people ask me about the likelihood of some of their thoughts and fears, such as “What happens if people don’t fly on planes for three months or more?” or “Can we survive if not one person comes to our restaurant for a full month?” or “What happens if people never go out again to shop and instead order everything from home?”
Until risk takers of all sorts can come to some sort of conclusion as to what to expect, action becomes impossible. In the present private equity environment, this is freezing up investments. Until probabilities can be calculated and a course of action can be deemed the appropriate risk-reward, inaction …read more