“In a moment of frightening enlightenment in 1993, I knew that I really did not know exactly how and why I had made all the money that I had over the prior 17 years,” he once wrote. “That threw my confidence for a jolt.”
And with the above quote from Paul Tudor Jones, Morgan Housel launches into his thoughts on the nature of risk and luck (which one should read immediately). Unlike Jones, I do not have 17 years of experience (let alone success) — however, I have had (and continue to have) moments where I wonder if I understand risk at all.
Understanding risk in public markets is difficult, but supposedly possible. Public companies will price daily, and discuss their financial health quarterly, which the financial press finds interesting. Private companies price, well, whenever they price. Their investors may have the right to receive financial statements from their portfolio companies, and the investors’ investors (limited partners) should have the right to receive financial statements for the overall portfolio. However, being private, investors and their limited partners will receive financial statements months after the end of a quarter — or the half-year, or the year, depending on whenever the companies agree to report.
Though this reporting delay is a feature and not a bug of private companies, it makes the matter of risk more difficult to understand. Further complicating this is the fact that investors typically have restrictions around how active they can be in managing their stakes in private companies (whether through becoming involved in the operations, or even selling the stake). The same goes for limited partners managing their stakes in funds — meaning that if one decides the risk in holding a private investment outweighs any potential returns, they’re going to have a difficult and/or bad time trying to sell it. Though monitoring a risky private investment is still a very useful exercise, its value mostly resides in teaching the parties involved what not to do in the future.
If the remedies available to private investors in their handling of risky investments are limited, then the actual risk mitigation needs to take place at the front-end. That is, before the actual investment has been made. This requires analyzing the people, products, markets, etc. involved, and in the context of risk will lead to the following questions: have the founders/investors shown prior success in executing this specific strategy, have they been consistent in their outcomes, and how do they protect against negative outcomes?
Strategies like control investing, growth equity, and venture capital/distressed investing may all differ in how they judge risk and ultimately perform, but the answers to those aforementioned questions should lean more towards yes than no. And in the cases where those answers lean towards no, there needs to be a rational explanation or else one shouldn’t trust the story of that founder/investor — which would be an issue, since investing (actually, everything) requires trust. However, strong performance does have a way of making investors and limited partners gloss over poor strategies. And if that does in fact happen, those investors or limited partners may wake up and realize they don’t understand how or why they are successful. Or merely just above average.