Reducing your downside risk

downside risk

 

There is risk in everything we do in life. There is risk crossing a road, driving a car and a risk getting on to an airplane. There is no way to completely avoid risk, but the skill is to manage it effectively. This makes the risk appropriate and worthwhile taking. Driving without a seatbelt is an example of terrible risk management. Though the chances of a crash are minimal, it costs you absolutely nothing to ensure that you are clipped in and this may save your life. There is no upside to driving without a seatbelt, only downside.

What is downside risk? 

Business is the same as any other aspect of life and involves risk. There is a risk the economy will implode like it did in 2008. There is the risk that your industry will shrink, or that your market will evaporate in the coming years just like typewriter makers will have felt when word processors entered the market. There is also opportunity and that is what good business is all about. In fact, sometimes there is great opportunity where the upside is so large it makes the risk worthwhile. If you risk £100 and stand to double your money with a 75% chance, that is a great risk to take on, because over time you will be making £150 for your £100 investment. If your chances of doubling your money are only 25%, you stand to lose over time.

As an entrepreneur or investor, it is important to take into consideration the risk of a venture. If you ever watch ‘Dragons Den’ you will see the Dragons haggling over the fraction of the company they will own for their investment. What are the chances that these businesses will succeed? At best the odds must be 50:50, but if the Dragon owns 10% of a company that goes global, they will more than have paid off for some of their investment failures. By improving the deal they take on, they are reducing their downside risk i.e. the amount of money they stand to lose overall.

How to reduce your downside risk

To encourage investment into new companies the government has set out the Enterprise Investment Scheme (EIS). This scheme allows investors to buy shares in an eligible company and receive income tax relief equivalent to 30% of the value of the shares. So if, over the course of a year an individual pays £10k in income tax, and they buy £10k worth of EIS shares, they would be entitled to receive tax relief of £3k (30% of their investment). In addition, if after the minimum holding period of 3 years, the shares would be sold for a significantly higher value, the investor would not have to pay capital gains tax. On top of this, were the investor to sell the shares at a loss, he or she would be entitled to loss relief. Loss relief means that if any capital gains were payable, this value could be netted off with the loss of the shares, again making this a more protected investment.

The EIS scheme is not for everyone, and does have some conditions that need to be satisfied, but it is a great example of improving your odds as an investor or entrepreneur. At the end of the day, the best investors and entrepreneurs build businesses by managing their risk appropriately.