S.E.C. Real Estate Observer

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Factoring in Risk?

Whether you think that the economy is actually heading for a financial reset and, in some scenarios, a catastrophic reset, or that the fiscal fear mongers are out of control and financial collapse is just a way to sell more books, there is one factor you must consider when counseling your client or investor: Risk.

In an uncertain macro-economic climate, how do we manage risk and try to foretell what investors (including ourselves) want and need?

Risk is ubiquitous. It is a component in every transactional scenario across the investment spectrum. It is also elusive—we may not know what type of risk we are trying to define and what that means to our clients.

How much growth should a company undertake and how should that be financed? What markets should our company abandon in anticipation of a market contraction?

History is replete with companies that adopted a strategy of vigorous growth and suddenly are no longer in existence. On the other hand, Wal-Mart is the latest example of a company that is strategically retracting from some markets.

The Wal-Mart example may illustrate a finding by two psychologists in 1979, Daniel Kahneman and Amos Tversky, who coined the term loss aversion; loss aversion is a component of their overall prospect theory. In a nutshell, Kahneman and Tversky argued that people are motivated more by what they may lose than what they may gain.  In all likelihood, Wal-Mart was forecasting how they couldlose if they remained in certain markets. This is just a thumbnail sketch of a much more complicated and statistically dense theory, but the idea is illuminating.

Take insurance as a simple example—one is willing to invest a risk premium in order to avoid loss instead of using that money to possibly earn a higher percentage of profit on that same amount of money. Psychologically, the chance of loss involves a higher degree of perceived risk.

The concept of loss aversion should be a part of your toolbox. It may not be good enough to convince a client or investor how profitable the deal may be; it may be more important to point out something concrete that they may lose without your solution. As important will be the assurance that your solution will not cause a significant loss, either financial or intangible.

I’m not discounting the idea of an enthusiastic positive approach to deal making, just a different approach to think about if the “rah rah” button doesn’t seem to be effective.