Skip to content
Author:

Calculated risk

Updated Tuesday, 3rd June 2008

Dr Brian D Smith looks at why some business ventures are riskier than others.

This page was published over five years ago. Please be aware that due to the passage of time, the information provided on this page may be out of date or otherwise inaccurate, and any views or opinions expressed may no longer be relevant. Some technical elements such as audio-visual and interactive media may no longer work. For more detail, see our Archive and Deletion Policy

The collapse of Silverjet, the low-cost, business class transatlantic airline, came quickly, with staff reportedly in tears and passengers arriving at the airport to find notices taped to the Silverjet desk. Arguments will continue over what caused their demise, be it oil prices or investors, but the collapse of this, and on average a third of all new businesses, serves to illuminate how risky business can be.

But the humorous adage about new business ideas – that the best way to make a small fortune is to start with a large one – masks some interesting detail. In fact, new business ideas range from the very safe to the very speculative and it is by recognising and managing those differing risks that investors make money.

All business plans have an inherent amount of risk due to the fact that they all, one way or another, make three basic assertions:

  1. The market is this big
  2. We’re going to win this much share of the market
  3. That share will make us this much profit

Of course, none of these assertions are guaranteed. They are all more or less educated guesses and, to the degree that they are uncertain, they imply risk. In simple terms, therefore, the risk associated with a business plan is the sum of the risks associated with each assertion as follows:

  • Market risk: the risk that the market won’t be as big as hoped
  • Share risk: the risk that the strategy won’t win the share it hoped for
  • Profit risk: the risk that, even if the sales are good, the profit margins won’t be what was hoped for

Calculating the risk [image © copyright Photos.com] Copyrighted  image Icon Copyright: Photos.com
Calculating the risk.

Clever business people realise that a careful reading of the business plan can reveal how big each of the risks is. For example, a radically new concept, like Glasses Direct, the web-based opticians, has a lot of market risk because nobody has any idea how many people will want to buy their glasses over the internet. By contrast, Apple’s iPod, although an innovative product, knew there was a market because it followed a trend set by the Sony Walkman. Share risk is a bit more complicated. It has a lot to do with how well targeted and compelling the offer to the customer is.

BMW, with its precise targeting of the driving-loving segment with “the ultimate driving machine”, has low share risk. By contrast, Woolworths, with its rather diffuse and outdated offer has high share risk. Finally, profit risk has a lot to do with the assumptions the firm makes about costs and competitor response. If you make optimistic assumptions about high prices and low costs, then assume that the competition won’t react, you’re taking a big risk. Silverjet suffered from some of all three risks, but it looks as if it was profit risk, created by fuel prices, that was the major reason for its downfall. 

What can managers and investors do about this? Is new business inevitably risky business? Well, yes, but there is something that can be done about it. In general, the more new elements a business plan contains, the riskier it is. That doesn’t mean don’t do it, it just means that investors should demand higher returns of new businesses and that conservative investors should chose more cautious investments. And if you do want to start or invest in a new idea, then the decades worth of research into risk have been distilled into a 15 point checklist to calculate and manage risk. 

In short, managers and investors have to take risks, but they don’t have to be uncalculated ones.

Further reading

Risky Business is on the Decline, MBA Business Autumn 2004. PDF available on request from the author at brian.smith@pragmedic.com

Marketing Due Diligence: Reconnecting Strategy to Share Price by MacDonald, Smith and Ward, Elsevier 2005

Against the Gods: The Remarkable Story of Risk. By Peter L Bernstein, Wiley 1996

Taking it further

OU Course – Financial Strategy (B821)

 

Author

Ratings

Share

Related content (tags)

Copyright information

For further information, take a look at our frequently asked questions which may give you the support you need.

Have a question?