The Importance of Risk in Entrepreneurship

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Risk is an interesting beast. Generally speaking, the goal of each entrepreneur and investor is to mitigate risk to as near zero as possible. The less risk that exists the better, or at least, the less risk you personally must take on, the better. This is a fine policy that any savvy businessperson demonstrates. Interestingly, risk plays an important role when viewed from the macroeconomic perspective. On the micro level, we are all trying to eliminate it, but from the greater macro level, it is an important regulator and guide to innovation and progress. To artificially eliminate risk poses some interesting side effects that ultimately are undesired. Forms of artificial risk elimination would include government policy and intervention, public incentives and credits, promises of government support and bailout, etc. These forms of risk mitigation are immediately accepted by most who are offered but is it really for the best?

The Role of Risk

Risks are what keep us on certain paths and help us avoid other, less profitable ones. The only time an entrepreneur tends to embark on a new venture is when the rewards outweigh the risks by a determined margin. Each has their own identifiers of risk and reward, some are better than others but internally, all entrepreneurs go through this risk/reward analysis (thoroughly or not is what depends). The importance of risk is the managed allocation of various forms of capital that it performs. It helps keep capital and resources (including human ingenuity) where it is most profitable. The role of profit is equally important and will be discussed at a later time. Suffice it say that profit reveals the most desired and needed innovations. If the venture does not demonstrate adequate profit as compared to the risk undertaken, the entrepreneur does not embark. Instead, that entrepreneur chooses to deploy the capital of that venture into one that demonstrates the necessary traits of risk/reward, giving us the more desired innovation versus the alternative less desired (due to lower risk/reward potential). Risk assists in minimizing wasted resources on ideas and ventures that aren’t necessarily desired or needed in society. If they were, they would pass with higher risk/reward results. If one chooses to embark on the lower venture anyway, the result will likely be business failure and/or lackluster results ultimately leading to closure or reallocation of resources. That particular entrepreneur will lose the capital to others who will hopefully be more productive with it, or if the lesson is learned soon enough, reallocate it to the more profitable venture before all is lost. Risk provides this service in the marketplace. Without it, we would have many more ventures that we don’t want and far less that actually move us forward as a society. Is it perfect? that depends. It definitely is continually working to close down inadequate ventures in favor of more adequate ones. This same idea can be applied to the individual entrepreneurs themselves as opposed to their ventures exclusively. That is, sometimes the right idea is with the wrong person, or a less capable one. Risk tends to reallocate capital in this way as well.

What does artificial risk manipulation do?

Artificial manipulation of risk really only exists with government entities, that is parties that do not carry a risk of failure. The government can impose assistance, guarantees, incentives, and otherwise that may not naturally exist, all without fear of failure (as they are the government!). Other private entities may pose similar incentives but they too run the risk of failure if capital runs out. Risk still exists for them so they will choose where they incentivize and do so with the same prudence as the entrepreneur will with the actual venture. They are simply an investor at that point. Essentially, an investor with a bottomless pocket and the apparent impossibility of failure is a very reckless and inefficient investor. This is the government with incentive programs that artificially eliminate risk. Now, if you incentivize entrepreneurs willing to embark on innovations in a particular industry, many will do so, of course. You are making promises of guaranteed results regardless of performance or actual profit potential, you are taking the risk thus artificially improving the risk/reward analysis to a point that makes entrepreneurial sense. Many ventures will suddenly crop up take on the new opportunities and innovation will occur. The important question now, is it the most prudent use of resources and capital for society? or simply made to appear as such through artificial risk elimination? Many times, this risk elimination can lead to less than efficient solutions to truly existent societal desires.

Currently, there is much being said regarding alternative fuel choices. My intention here is to illustrate a point about choice of solution and not whether or not the desire itself is artificial. If we, as a society, decide we need an alternative to fossil fuels, we are left with many possibilities. The risks of each will reveal themselves and entrepreneurs will begin developing their ideas. After each idea is created and developed, the unintended consequences will reveal themselves as well and profit and other market results will begin to identify the best choice of alternative, eventually leaving the other options to dwindle and eventually be reallocated to more efficient capital uses. This allows for maximum progression with the given resources in society, again including human ingenuity. Now, lets artificially remove some risk from the equation of choices. Lets say, electric cars are incentivized where the other options are not. Naturally, hydrogen vehicles may have been the optimal choice, however electric begins to received substantially more capital allocation due to guaranteed results and support of government agencies. Hydrogen may develop still but considerably slower than electric as it still carries full risk. In fact, it now has additional unnatural risk through new competition with the incentivized electric. Electric will dominate, regardless of many long-term unintended consequences. Some examples might include skyrocketing electricity costs and demand that affect not only fuel for vehicles but home operation, business operations, and the plethora of other uses of electricity. Eventually, the better solution may come out on top but only after considerable time and adjustments in public policy following less-than-spectacular consequences of previous policy. This is only meant to serve as an example of the dangers of artificial risk elimination and is not my opinion on any alternative fuel choices. I am not well versed enough in this area to say either way at this point.

Embracing Risk

As I mentioned earlier, on the micro level, meaning you and your business, the mitigation of risk is a necessary trait of good business. Every entrepreneur ought to take the steps necessary to do so but now with an additional appreciation of risk. Risk will also eliminate much of the competition, opening the market to the real solutions versus it being clogged by too many second-rate alternatives. The risks of your business will keep you efficient and on your toes. This is why it can be very productive to bootstrap a business. Bootstrapping a business poses additional risks that are eliminated by a large capital injection. This risk causes the efficient use of each dollar. Costs are analyzed much more closely and the most profitable ideas and offerings (the most desired ones by the marketplace) are developed first. The experience ought to be had by every entrepreneur at least once. Funding a business poses its own risks as well and that route is fine, however, bootstrapping tends to teach efficiency and develops business skills to a degree often missed in other settings. Embrace what risk does for you as an entrepreneur.

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