The Risk/Reward Relationship. Constantly Re-defined. Constantly Revised.
When entrepreneurial achievers build their better mousetraps they frequently put everything on the line. Young, gutsy, let's-go-for-it achievers are our economy's strongest allies. Everything begins somewhere, and the entrepreneurial person is often the spark plug. With entrepreneurial success comes monetary reward, which in turn changes the Risk/Reward Relationship.
An entrepreneurial friend sold his company at age 52 for almost five million dollars. It was the first time in his life he really had any excess cash. He and his wife stayed in the Midwest for a year, then moved permanently to Arizona. He had stars in his eyes and money in his pocket. The stars stayed. The money didn't.
Even though certificates of deposit would have been just fine, he wanted to show Arizona how to develop property. Unfortunately, he ran into some folks who wanted to help him, or so he thought. He became involved in about every quick-buck real estate deal south of Flagstaff. When prices plunged shortly afterward, he came close to losing everything but his underwear. He was able to hold on long enough for his real estate to partially rebound, then escaped with enough to keep the college tuition promise he made to his grandkids—and just enough to retire on.
What did my friend do wrong? He made two major errors. The first was becoming involved in a business he had no experience in. The second error, and the more significant one, was in not re-defining and revising his risk parameters—a requirement issued to him on the day he accepted his multi-million dollar check.
Acceptable risk levels are not constant. They change every time one's financial position changes. Oddly, they change in a direction opposite the prevailing wisdom.
It appears at first glance that the more money you have the more risk you can take. True and false. True because the absolute amount you can put at risk increases as assets increase. And false because increased assets give us more to protect. While the absolute amount put at risk may be greater, the amount as a percentage of personal wealth should become increasingly smaller. That's what my Arizona friend forgot-he went south with a bagful of money and put it all at risk in leveraged, highly speculative ventures.
Pure financial theory suggests that risk doesn't exist when assets aren't at risk. Theoretically, therefore, risk increases as wealth increases.
What level of debt can you responsibly afford to assume? There are three answers:
- A debt predictably covered by personal earnings.
- A debt that will fund itself by way of increased cash flow.
- A debt that is offset by savings or other ready cash.
Assuming leverage beyond that, especially by someone with considerable assets, is not advisable.
The more wealth you have, the more conservative you should be when analyzing what percentage of it to put at risk. Again, the absolute amount may increase, but as wealth increases, the relationship of at-risk funds to total assets should consistently be reduced. The three R's: Risk to Reward Relationship—is one relationship that should always be changing.