Published in the San Diego Union-Tribune, March 20, 2017
When I play golf with a couple of my cronies, this is what I hear at the first tee. “The bet is a $5 Nassau, automatic two down presses, shut up and tee the ball.”
At this point I have learned (painfully) to ask my associate “What is the most I can lose?” His answer is fascinating. “If lightning doesn’t strike, and you don’t play like crap, maybe $15.” But he is talking to me about the odds on the outcome of the game — not the risk. The risk is simple and mathematic. I can potentially lose 12 ways, and I could lose $60. The press bets are ones that only an accountant can truly delight in.
But the odds (different than risk) are that given reversion to the mean, we are probably only exposed to $10 or $15. Often enough after four hours of battling and trash talk, we end up “all square.” The only thing left is for someone to buy the onion rings.
So let’s see how learning the difference between the odds and the risk applies to our entrepreneur. Risk is the potential of gain or loss. It is what the venture capitalist thinks about when he makes his financial bet. The company and the investors collectively are “intentionally interacting with uncertainty.” Think about the big insurance companies. The reason they have so much money is they are really good at two things — managing and measuring risk and not paying quickly (can’t help myself on that one). Uncertainty’s handmaiden is “in retrospect.”
The recent IPO of Snap was passed on as an initial investment by several big guys. One prominent one “never even took the meeting, although I was asked and knew about the company early on.” We all could use the “look back machine” — or in golf, the infamous mulligan.
Now let’s look at the odds. Odds are a numerical expression that reflects the likelihood of an event taking place (e.g. the Padres winning the pennant in 2017). Las Vegas is really good at this game. Remember, those large casinos were not built because you won the money. Odds reflect relative probabilities. In my case, even a blind squirrel can make a par occasionally.
Next, let’s factor in my favorite concept — “The Black Swan” a book by Nassim Nicholas Taleb. It was published in 2007. Note that 2008 was the next year up. If Lehman Brothers had read the book, they might still be around. The book focuses on the “extreme impact of certain kinds of rare and unpredictable events.” The corollary in the book is that we humans tend to find simplistic explanations for these events — the famous “in retrospect,” which is always 20-20. We foolish humans suffer from both cognitive and confirmation bias.
One big idea in Taleb’s book is that we tend to misprice the likelihood of big adverse events. We think that the odds of a hurricane are minute, when in fact, statistically, it is much more likely. In other words, we humans do not plan well for big dislocations; we do not build robust companies or institutions or even societies to withstand the big blow. The current Trump administration appears to be more random than most, and thus the likelihood of a black swan event (a tweet sent to North Korea by mistake that was intended for Melania) is greater than zero. And so the odds and the risk get multiplied exponentially.
So how does our intrepid entrepreneur go about building his company, learning to understand risk (we could go broke and fail miserably), the odds (we are getting some traction with early adopters; if we can scale slowly, we can survive until the next funding) and the black swan (our patent is overturned and found to be invalid) or the government attempts to shut us down (Theranos).
This brings us finally to the “gamble.” The gamble is that we will get there before we die or get crushed. To do that, we measure the risk and the odds, and we anticipate dislocations so we wear a belt and suspenders (multiple redundant servers, cybersecurity, do not bet the farm on one large customer, hire diversity in the team, manage with humility and focus, etc.) But even with all that, we are still at the mercy of the gods.
Rule No. 502: The start-up game is complex but still not as bad as the press bet.