Taking Risks

White Horse Ledge, NH

White Horse Ledge, NH

There is a huge difference between security and freedom.  When you’re most secure, you’re the least free and vice versa.  Just like the robot brain in the movie “i Robot”, the humans are safest (most secure) if/when they are all locked up, with no possible interactions with other humans.  When we are at our  most free, we are able to do what we want; we are also able to take risks which may cause us to stumble, maybe even stumble a few times.

Look at many of the great leaders and entrepreneurs of the past 150 years.  How many failures did Thomas Edison have before he found the correct filament for the light bulb?  How many times did the Wright Brothers design aircraft before they hit the right design?  Richard Branson’s first business (Student Magazine) was a failure.  Abraham Lincoln was quite unsuccessful until he was voted in to the Presidency.  Elon Musk was almost bankrupt before he founded Solar City and pushed Tesla Motors to the apse of EVs.  Even Henry Ford failed three times before he established the Ford Motor Company.

Failure is to be embraced so long as you learn from your failures and don’t repeat your mistakes.  You will always learn more from failures than you do successes.

Our freedom allows us to take risks.  Risk leads to reward but risk and reward are always related.  The more risk you shoulder, generally the higher potential reward, but also the higher the potential calamity.  You want to evaluate any situation to determine if the potential reward is worth the risk.  Think of the Mercury and Gemini astronauts.  There was HUGE personal risk, but they’re all national heroes.    Imagine the marines assaulting the beaches in Normandy on June 6, 1944.  There was enormous risk, but the reward, a liberated Europe, was well worth the risk.

In business, you want to quantify and reduce your downside risk while increasing your potential reward.  There are ways to reduce the risk, but you have to realize that you will never entirely eliminate the risk involved.  If you entirely eliminate the risk, you entirely eliminate any potential reward.  Is that a good investment?

For my investments, I have developed an Annual Property Operating Data sheet (see: Resources) which allows me to very quickly assess a property’s potential reward by using known quantities including: existing leases, utility information, tax and insurance quotes, assumed repair bills, property management fees, etc.  Based on this information, two properties may appear very similar, but because of existing leases, or minor differences between the properties, one property may offer a significantly better investment opportunity (lower risk) than the other.

To further reduce my risk, I prefer to purchase undervalued properties that offer equity by improving the property as well as positive income from the rental of the property.  I will specifically look for ‘unique fixer-upper opportunities’ (UFUOs) to increase my equity while knowing the improvements to the property can be financed through the monthly rent.  My first two properties had unique challenges, but also offered increasing rewards.

The first property I purchased was a single family home that needed a few electrical updates, minor plumbing updates, paint and new flooring on the first floor.  I purchased the property for $17,500 cash in August 2012 (see: How Do You Ask for Loans?).  Within in two weeks of my purchase, I rented the property for $825 per month (utilities included; max electric of $100).  I spent approximately $3,000 on the improvements to the house.

The improvements to the property were relatively low risk (for me).  The improvements forced me to stretch my existing skill set slightly outside my comfort zone, but I knew that the improved house was worth at least 2x what I paid for it (see: How to Value Homes; What to Do with Your Equity).

The second property I purchased was a duplex that was only half rented which represented increased risk to me.  The purchase price was $40,000 with a $2,000 owner assist for an effective purchase price of $38,000.  The half of the duplex that was not rented needed a full electrical update, plumbing upgrades, new flooring, a new kitchen, a new bathroom, new flooring and some plaster/drywall work, including painting the entire duplex (see: UFUO #2 and updates).

The work needed to improve the duplex represented a significant risk if the potential increase in equity did NOT at least cover the costs.  Going into the rehab work, I knew the increase in equity would cover the costs by at least 1.5 times (mostly because of my labor savings).  The $11,000 I invested would return at least $16,500 in equity which is a good investment according to my personal criteria.  (please note: Based on research after I started this project, I believe I should be able to increase the equity by about $25,000.)  When I’ve finished the half duplex, I will provide some follow up to see how accurate my estimates were.

By initially estimating the single family home was worth at least double what I paid, and the duplex would return $16,500 on an $11,000 investment, I was hedging my risk.  Even if I overestimated the value of the single family home by 50%, I would still break even on that investment.  I played my duplex more tightly, allowing for only a 33% overestimation for a break-even (Assuming my down payment is not lost; eg: $16,500 x 33% = $11,000 investment).

Understanding and quantifying your risk is extremely important.  Most of my calculators have some built-in, not-quite-hidden hedges against risk (see: Resources).  While these hedges will never fully eliminate risk, these calculators should allow my estimates to be more conservative (eg. reality will be more lucrative) while providing me with a level of comfort with my investments.  HBS has owned the single family home for 12 months, and the hedges have proven successful.  I need to wait until I’ve owned the other duplexes for at least a full 12 months before I can make an assessment on those investments.

When you begin your venture, you need to fully understand your exposure.  What is at risk?  Is it only the money involved in your venture?  For me that is the down payment.  My wife and I discuss our investments and while we don’t directly ask “Are we willing to lose this money,” we do discuss other options for our money which may carry a larger margin of safety.  Your venture may be tied to your house.  Are you willing to lose your house for your venture?

Make sure you understand your risk and have an appropriate margin of safety.

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