Analyzing risk and reward is a quality one must possess to make the best decisions possible in their pursuit of financial freedom. Some people shy away from anything that can be perceived as “risk” completely, while others sit on the other end of the spectrum by taking risks that are uncalculated and not well thought out. Being able to break down a decision before you make it by determining the potential pitfalls beforehand and weighing that against what you stand to gain on the other side of things will make sure you make the best decisions possible for your success. The word “risk” scares a lot of people because they presume it is “bad” in nature without actually going through the upside and downside of taking that risk. This is the beginning of the problem when it comes to analyzing risk and reward.
The inherent risk of taking no risks
Shying away completely from what the system would refer to as “risky” is a risky thing to do in itself. To generate wealth through the accumulation of valuable assets requires people to step outside of what would generally be perceived as their comfort zone. The system tells us to go to college, get a well paying salaried job with job security, a 401K or a pension so you can save for retirement, and to step outside of those lines can be scary and risky. Financial freedom and wealth is built outside of those lines and if that is a goal you want to reach you’ll have to break these standards set by the system or you’ll risk not reaching that goal of financial freedom. Taking calculated risks investing in wealth generating assets or learning a money generating skill to add value to society all involve some level of risk. You could fail. You could lose money. Bad things can and probably will happen along the way. But depriving yourself of these experiences stunts your growth as a person. It is because of these experiences that make us who we are. It is because of the hardships we face that we learn to persevere. Not taking any risk at all is inherently risky because you’re depriving yourself of the freedom to fail and the right to succeed.
How do I know if its worth it?
Calculating risk and reward is like playing a game of tug of war where risks pull you away from doing something and rewards pull you towards doing it. In order to make the best decision, you need to eliminate all bias towards that decision upfront, giving the risks and benefits an equal playing ground in their battle of tug of war. Start with the worst and best case scenario outcomes of the decision. Can you live with the worst case scenario? Is the best case scenario worth taking the risk of the worst case scenario? Do you have the knowledge and the ability to pull off what it is you’re trying to do? These are some of the questions to ask yourself when analyzing risk and reward. Right the answers to these questions out on a sheet of paper on opposing sides of a chart. The last thing you want to do is make a half-baked decision where not all questions are answered upfront to only realize later that you made the wrong decision. The biggest key is to take emotion out of the decision-making process as much as possible to come to your final verdict. Below is an example of me going through my own risk analysis process. Remember, losing time is just as if not more detrimental than losing money (in my opinion it’s more detrimental because you could make more money but not time), so when you calculate risks and rewards, take that into account as well.
Decision to be made: Should I purchase the investment home at 123 Main Street?
Upside/Reward:
- I can buy the property for way less than its worth
- I can take over the existing mortgage at 3% interest
- The market rent for the property is $2,000 a month and my monthly payments including taxes and insurance are $1,400
- The seller only wants 10K cash to him at close
- People are moving to the area and it is growing
- **There are multiple exit strategies I can use on this property to make money**
Best case scenario:
- We use one of the three or four profitable exit strategies on this deal to make money. We either will have a cash flowing asset for little to no money out of our pocket, or we will have sold the property at a profit on the back end.
Downside/Risk:
- The property needs about $20,000 of work to be considered in good condition for the market
- There is a tenant in the property who is delinquent on their payments and the owner has begun the eviction process
- The seller’s attorney is a headache we have to overcome constantly until the deal closes with constant objections even if we have already answered the same questions
Worst case scenario:
- We get stuck with a non paying tenant we can’t get rid of. (Solution: Make the contract contingent on the tenant being evicted. We won’t inherit tenants going through an eviction. Or, we delay the down payment to the seller until the tenant is gone. There are multiple workarounds here).
- None of our three or four exit strategies work. (The likelihood of this is as close to 0 as you can get if you understand the viability of each exit strategy correctly in this scenario.)
Verdict:
- Based on the risk/reward analysis of this deal, it has become apparent to me that pursuing this asset is a wise decision. Due to our ability to overcome worst case scenarios fairly easily, the risk is greatly outweighed by the reward.
Synopsis
As you can see based on our risk/reward analysis of purchasing 123 Main Street, we were able to come to the decision that making this purchase is a prudent move. Writing out risks and rewards allowed me to understand and grapple with the worst case scenarios to see if it’s something I’d be comfortable with. In this case, I was able to overcome one of the worst case scenarios by simply brainstorming on the spot based on what I know. The other main worst case outcome to me was not a risk I was objectively threatened by due to the strength our multiple exit strategies provide. When you make decisions such as these, going through this process simplifies everything so you can clearly see both sides of the aisle and make the best decision. Don’t be so quick to dismiss things you react emotionally to until you do a risk reward analysis. You may be surprised by what you find.