September 21, 2023

October 27, 2023

The Relationship Between Risk and Return

Howard Marks' latest memo dives in on risk / return in the world of investing. Lots of frameworks and lessons from the piece can also be applied to business building.

pascal's notes

Episode Transcript

I read Howard Marks’ memos religiously.

No one is better at explaining complex topics related to investing in the simple and clear way he does. And often, the lessons he shares in and around investing are applicable well beyond the world of generating financial returns too.

In his most recent memo “fewer losers or more winners”, Howard discusses the role of risk bearing.

In school, like him, I was taught to view the relationship between risk and return as follows:

Bell shaped probability distributions

Howard argues regarding the risk / return framework:

The more I thought about it, the more unhappy I was with the way the linear presentation of the purported relationship tells investors that they can count on achieving higher returns as a result of taking more risk. After all, if that were really the case, risky investments wouldn’t be riskier. Thus, in my memo Risk (January 2006), I suggested a different way of depicting the relationship by superimposing on the line a series of bell-shaped probability distributions turned on their side:

Rather than implying that taking more risk – moving from left to right in the graph – assures higher returns, this new way of looking at the relationship suggests that as you take more risk, (a) the expected return increases, as per the original version above; (b) the range of possible outcomes becomes wider; and (c) the bad possibilities become worse. In other words, riskier investments introduce the potential for higher returns, but also the possibility of other less-desirable side effects. That’s why they’re described as being riskier.

This is a simple yet great way to think about taking risk both within investing as well as beyond, including company building.

Within investing, the graph looks as following (from his memo):

Treasury bills / bonds sit on the low risk end of the spectrum while the world I live in - venture - sits on the risky end where some funds will return >10x while more than half the funds raised return <1x. Making manager selection, portfolio construction, etc even more important.

In company building, the framework from above regarding risk / return and distribution of outcomes is applicable to most high impact decisions you’re making. This includes the very important decision re how to best finance your business / growth:

  • Bootstrapping sits on the left where the variance of outcomes is typically within a relatively narrow band.
  • Raising venture capital the other hand sits on the right again: The odds of a venture backed business going to 0 are much higher. Combining that with founders and operators spending many years working long hours for a sub market comp with the hope of their equity turning into a very valuable asset one day means that in the downside scenario, “the bad possibilities become worse” as Howard puts it. On the flip side, when it does work out, the result is life changing for everyone involved - including investors in the business.

This simple yet powerful framework is a good one to think through again the next time you have an impactful decision to make.

Alpha

To add to the framework - towards the end of the memo, Howard also talks about “alpha” (i.e. individual investing skill).

Investors who possess alpha have the ability to alter the shape of the distributions in the graphs above so that they’re not symmetrical, in that the portion of the distribution representing the less desirable outcomes is smaller than the portion representing the better ones. In fact, that’s what alpha really means: Investors with alpha can go into a market and, by applying their skill, access the upside potential offered in that market without taking on all the downside risk. […] the key characteristic of superior investing is asymmetry – having more upside than downside. Alpha enables exceptional investors to modify the probability distributions such that they are biased toward the positive, resulting in superior risk-adjusted returns.

If alpha is the ability to earn return without taking fully commensurate risk, investors possessing it can do so by either reducing risk while giving up less return or by increasing potential return with a less-than-commensurate increase in risk. […] Almost no investors possess both forms of alpha, and most possess neither. Investors who lack alpha shouldn’t expect to be able to produce either version of asymmetry – that is, to be able to generate superior risk-adjusted returns. However, most believe they do have it.

Harsh words. Yet, historical returns across asset classes confirm that most investors don’t possess alpha (i.e. don’t consistently outperform vs expected returns).

It’s something we think about a lot at focal - how do we create alpha / consistently outperform as a pre-seed VC firm in a venture market that is as crowded as it is / in an asset class that has such a wide distribution of outcomes? We believe we have an answer, are leaning into it as a firm and are betting the next decades of our professional lives on it. Whether we’re right, we’ll find out in a few years from now.

Like the risk / return framework, the concept of alpha doesn’t just apply to the world of investing but also business building.

Figuring out where you have an unfair / asymmetric advantage to have more upside than downside vs the rest of the market very much matters in the startup world too.

Founder domain expertise, a unique (non-obvious) insight, a significant strength in a skill essential to the business you’re building are amongst the things that can positively change the probability distribution of outcomes. Thus, we spend a lot of time looking for such “alpha” when we diligence pre-seed startups. And so should you as a startup founder / operator when thinking about what to build your company around / double down on. After all, you can only do one / very few things well at once with limited resource.

It’s hard / rare to find such an unfair / asymmetric advantage and more often than not, we get it wrong. But when we get it right, it can be life changing for both the founders we back as well as for us.

If you haven’t done so already, I can highly recommend signing up to Oaktree’s / Howard Marks’ insights.

Pascal

Featured Resources

June 6, 2023

June 7, 2023

Introducing findfunding.vc 🧨
We're thrilled to announce the launch of our open source VC database - findfunding.vc
company news

April 26, 2023

April 26, 2023

focal is live 👋
We just launched our firm's new name and bold brand: focal
company news

February 22, 2024

February 28, 2024

Early vesting is broken!
At startups, too often, too much of the cap table is owned by individuals who left before things started to work, causing resentment amongst the ones who made it work. Early vesting needs rethinking.
pascal's notes

October 19, 2023

October 27, 2023

What it takes to raise capital in 2023
The fundraising environment remains tricky to navigate for startups. Frameworks, like Point 9’s renowned SaaS funding napkins, offer a good a good temperature check on the early stage funding market.
pascal's notes

September 29, 2023

October 27, 2023

Cold Outbound is Under-Appreciated
To get to their initial B2B customers, most founders first tap into their network. That works well for some, but leads many others down a wrong path. Cold outbound is an under-appreciated alternative.
pascal's notes

July 13, 2023

July 20, 2023

🧱#8: The VC Rebrand Guide
Rebranding and revamping your website is no easy task. We lay out step-by-step how we did it for focal, all the way to launch.
brick by brick

April 12, 2023

April 25, 2023

🧱#7: Navigating Year-End
Now that the busy year-end season is (mostly) behind us, we look back at the operational lessons we've learned in the last six months.
brick by brick

March 20, 2023

April 25, 2023

🧱#6: On Point Offsite
In January, we had a week-long team offsite across Virginia & Miami. While the primary draw was to see each other, reconnect, & align, we also got a ton of work done. Here's what we learned.
brick by brick
No items found.

June 5, 2024

June 5, 2024

5YF Episode #17: Colossal Biosciences CEO Ben Lamm
Defeating death, programming life, resurrecting the Woolly Mammoth, AI’s blueprint for biotech, and the future of genetic engineering w/ Colossal Biosciences CEO Ben Lamm
5 year frontier

May 22, 2024

June 5, 2024

5YF Episode #16: Epsilon3 CEO Laura Crabtree
Space command reimagined, automating mission control, new deep tech hubs, interstellar missions, and the future of space operations w/ Epsilon3 CEO Laura Crabtree
5 year frontier

May 8, 2024

May 8, 2024

5YF Episode #15: Bright Machines CEO Lior Susan
Factory automation, humanoid robots, digital twins, building the backbone of AI and the future of manufacturing w/ Bright Machines CEO / Eclipse VC Lior Susan
5 year frontier