Google isn’t the arbiter of truth in this world, but it is an arbiter of truth, and if you google “medium risk investments” today, here’s what the search returns at the top:

Really?

Sure, “medium risk” is an appealing profile. It implies a good return opportunity and a lower chance of losing your money. But look at those medium-risk opportunities. Crowdfunded real estate? Yes, real estate has tangible value, but a crowdfunded deal means the professionals passed (not a great sign). And maybe you heard that interest rates are rising. That makes the carrying cost of real estate that much more expensive. As for dividend-paying stocks, describing them as medium-risk is painting with broad brush strokes. Some fund their dividends through debt, meaning their yields are just eating up their equity, while others, such as mortgage REITs, take on real risks to fund payouts. 

Corporate bonds and preferred stocks? Those are just more senior securities on corporate cap tables, which means you are capping your upside in return for that position. But, even if you’re senior, good luck getting your money back if a company goes bankrupt. 

And municipal bonds? There are tax advantages, but talk about a situation with more downside than upside. That brings us to risk.

When we last wrote about risk, we defined it as the “likelihood and magnitude of permanent loss.” But what have we reaffirmed about risk in the seven(?!) years since we wrote that piece? It’s that anything can (and will) go down substantially in value, and maybe all the way to zero.

In other words, there is no such thing as medium risk.

All investing is taking risks

But there is more nuance to it than that. Improbable things happen more often than you’d think, and probable things frequently fail to happen; that’s uncertainty, and uncertainty is at the root of risk. In fact, we concluded our last go-round on this topic by saying that rather than walking on the risk high wire we preferred our companies on two-by-fours about six inches off the ground.

Given that, you might think we are advocating for a low-risk approach. In fact, we love risk. We don’t eschew risk either in our operations or our investments. Instead we acknowledge that everything is risky. No business can expect to win big long term while only trying to walk on two by fours six inches off the ground. Rather, what we’ve learned is that we want our business walking on moon shoes (that’s a terrible analogy, but the point is we want to make decisions where we don’t have far to fall but have lots of room to jump). Therefore we want to do things that not just compensate us for the assumed risk we are taking, but could pay off huge. (Note to regulators: This is not a forward-looking statement nor an indication of future results, but a mindset.)

In her book Thinking in Bets, which is fundamentally a meditation on how to think more purposefully about risks and to better understand the risks you’re taking, Annie Duke writes, “We routinely decide among alternatives, put resources at risk, assess the likelihood of different outcomes, and consider what it is we value. Every decision commits us to some source of action that, by definition, eliminates acting on other alternatives. Not placing a bet on something is, itself, a bet.” 

So if everything can go to zero, including not doing anything at all, we think you should only bet on things that have the optionality to go really, really well if they work.

What that’s not

Over the years, we’ve reviewed thousands of construction companies. The industry was boring, it made money, and it was in demand. But here are two truths we’ve learned about construction:

1. It’s very competitive.

2. When things go bad, they go really bad.

The reality of those truths is that most construction companies have a capped upside and unlimited downside. If you’re the best in the world, your margins are limited by the pricing of your competitors’ bids. Yet if you’re on a big project and things go wrong, you have nearly unlimited downside in order to make things right and avoid liquidated damages. Further, things can go wrong for lots of reasons outside of your control. If you’re drafting business models, that’s not one you’d take with the first pick. It’s all downside variance.

What would you take with the first pick? If you believe there is no medium risk, then that would be something that has the potential to go to the moon if things go well. We call this upside variance. 

A business with upside variance would be asset light, require minimum reinvestment, get paid upfront, have recurring revenue and high margins, and be marketed by word of mouth. While we readily acknowledge that that specific business or investment does not exist, businesses and investments with those characteristics do – then the amount of upside variance you capture as an operator or investor becomes a function of what you pay for it.

Price is what you pay, upside is what you get

For most of us, everything’s framed against price. In fact, we’ve come to believe that paying a high price for something is effectively the same as levering it up: you put pressure on people to perform and shorten your time horizon to deliver that performance.

But “price” is more than dollars. It might be any one of a number of controlling factors: opportunity cost, culture fit, customer/supplier concentration, etc. In any business relationship you enter into there’s the cost and a range of potential rewards. 

To share just one example, we invested in a business alongside a materially involved owner, but we got comfortable with the key man risk because he was committed to staying involved and building out a management team over 5+ years. The deal was structured to honor that commitment. And then, in an unfortunate turn for much more than our deal, he got sick. It turns out, no matter how well-intentioned all parties are, you can’t control the universe through a purchase agreement.

If you can minimize the cost and tilt the range up and to the right, you win. But if you cap your upside in a world where there is no medium risk, you will inevitably lose. Or as Warren Buffett described his decision-making process: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.”

So here’s the triangulation: What’s the downside of the decision? What’s the upside? And what’s the price you pay? With those variables outlined, the point is to try to create more upside variance every day.

Disclaimer: The information, opinions and views presented in this article are being provided for general informational and educational purposes only and are not intended to constitute and do not constitute legal, tax, accounting or investment advice of any kind. All such information, opinions and views are of a general nature and have not been tailored to and do not address the specific circumstances of any particular individual or entity. Nothing in this article constitutes professional and/or financial advice, nor does it constitute a comprehensive or complete statement of the matters discussed herein.

For more musings on risk and reward, subscribe to Unqualified Opinions, a daily newsletter from CIO Tim Hanson.