Assessing your risk tolerance

David shares the framework he used to determine whether ETA was the right fit given his risk tolerance and long-term goals.

My life and risk

I view myself as a relatively risk-averse person. Though I may not hide in my apartment all day to avoid the dangers of the real world, I am continually assessing how I can maximize my ‘risk-adjusted returns’ in life. I wouldn’t say I like risk, and I don’t think many others do either. Living with uncertainty for long periods can severely strain our mental well-being, and we are seeing some of the effects of that coming out of this pandemic.

However, I observe a high correlation between uncertainty and personal growth if one can manage it properly. So here we have this paradox; uncertainty stresses us out but can make us stronger individuals. In assessing my risk tolerance, I always believe that more uncertainty keeps my mind strong and agile and may not necessarily mean ‘more risk’.

What do I even mean by the word ‘risk’? According to Merriam-Webster, risk is defined in four variations: the possibility of loss or injury, someone or something that creates or suggests a hazard, the chance of loss or the perils to the subject matter of an insurance contract, and the chance that an investment (such as a stock or commodity) will lose value. Since we are discussing risk related to search fund entrepreneurs, let’s align on using the last definition, where such investment is yourself. 

Let’s play a game

I digress for a moment to demonstrate how abstract and subjective risk as a subject can be with a short mental exercise. Don’t worry. I will avoid any risk and utility models you may have encountered in various economics courses. Okay, now let’s begin. 

I’m going to offer you a (hypothetical) deal. You get $10 with certainty or a 1% chance of receiving $1,000 and a 99% chance of receiving nothing. Take a second and think. What did you choose? 

Now, let’s up the stakes. You get $1 million with certainty or a 1% chance of receiving $200 million and a 99% chance of receiving nothing. What did you choose this time?

In the first game, the expected outcome of each scenario was $10. You always receive $10 in the first outcome and an expected value of (99% x 0) + (1% x $1,000) = $10 in the second. If we are risk-neutral individuals, we would be indifferent between the two choices.

In the second game, the expected outcome of each scenario was $1 million. You always receive $1 million in the first outcome and an expected value of (99% x 0) + (1% x $200,000,000) = $2 million in the second. If we are risk-neutral individuals, we should have chosen the uncertain option this time, given its higher expected value. I guess that most of you probably would have taken the $1 million with certainty. In essence, that’s being risk-averse.

As we can see, decisions in life aren’t that simple. Decisions depend on the context of the situation and are much more complex. We can’t put expectations on every decision we make, and we all operate under very different circumstances. One’s risk tolerance is personal, and people may assess situations differently, but the following framework is relatively simple and should help you tackle this mysterious concept with a bit more comfort.

A simple framework for thinking about risk tolerance

Many portfolio managers and financial advisors provide risk tolerance assessments that you can find online for free. I took one from the University of Missouri (link here) and scored a 28, which classified me as having moderate risk tolerance. It turns out I am not as risk-averse as I thought, but still, the questions can’t correctly identify the complexity of my own life. Instead, I like to use an alternative visual method that plots our ‘capacity to take risk’ on the x-axis and our’ willingness to take risk’ on the y-axis. For simplicity, please ignore the ‘Cash’ category and include it with the orange ‘Conservative’.

Willingness to take risk

An essential element of determining our risk tolerance is to think hard about how much risk we are willing to bear. Let’s unpack that a little bit. Whether one is ready to deal with uncertainty in the context of search funds depends on several factors. 

Are you deeply interested in entrepreneurship and ETA more specifically? Do you have experience working in unstructured environments? Anything that can prepare you for an entrepreneur’s lonely and challenging journey will help you determine these questions more seriously. Further, are you known for your mental toughness and perseverance, or do you give up when the going gets tough? Can you point to numerous examples in your life when you built yourself from the ground up? How about your willingness to take action on tasks in life – do you have a bias towards action, or are you a procrastinator? Finally, what is your optimal time horizon? Long-term thinkers are much more willing to sacrifice the missed opportunities in the short run to achieve something much more significant.

I did this same exercise when considering my willingness to take risks before White Cedar. My assessment began before I even started business school. My deep reflection taught me that I was a terrible corporate employee - I often struggled with the hierarchy, structure, and inefficiencies. It taxed me mentally every day I was a part of it, even though I loved the companies I worked for and their people.

However, given my upbringing and time as a competitive basketball player, I knew that I preferred unstructured environments. Basketball taught me discipline, perseverance, and mental toughness that comforted me in dealing with the uncertainty of pursuing a search fund. Finally, I tend to make decisions that I believe will best benefit me 20+ years from now, even at the expense of my current satisfaction. A search fund was perfect for that longer-duration career path I was itching for. So with all of those factors, it was relatively easy to score quite high on willingness.

Capacity to take risk

On the x-axis, we must now consider our capacity to take risks. This again is a highly individual and subjective exercise – I argue more so than our willingness – but equally necessary. There are three categories to consider within this assessment: personal, financial, and career.

From a personal perspective, a potential searcher has many moving parts that involve others. Are you married? Do you have children? Is your partner willing to relocate with you in the event of an acquisition? If you’re single, can you bear the loneliness of the search without having ample time to date? Will you be able to fit in culturally in potentially a rural market?

Tied to your personal responsibilities, maybe you have a mortgage, student loans, and other financial obligations to take care of in the immediate future. Can you right-size your lifestyle to bear the opportunity costs of a traditional search? How long can you search self-funded if you decide to pursue that path? Are you expecting children, tuition, or other future expenses that could further limit your capacity? These are essential questions to keep in mind.

Certain career considerations add a layer of complexity to the situation related to both personal and financial. If you are working a full-time job, are you expecting a promotion or stock vesting in the foreseeable future? Are you willing to bear the loss of prestige in working at a big-name firm and the network that comes with it? These factors are particularly tricky since we humans tend to find every excuse possible NOT to do something. We wait for the perfect opportunity to arise, only to wish for an even better situation to leap into entrepreneurship. This path requires considerable sacrifices, so there is no correct answer for a threshold to make you ready. Let me walk you through my logic.

I’m 29 years old and fortunate enough to have a partner that fully understands and supports my decision to pursue ETA. I don’t have kids, a dog, or a mortgage, but I have some student loans. In the past ten years, I’ve lived in six cities (Ann Arbor, Ithaca, New York, San Francisco, Chicago, and London) and moved much more. I’d love to plant roots at some point, but I am comfortable being on the go and doing this again. Coming out of business school, I knew my primary considerations were alternative job opportunities to ETA that are common for most MBAs. However, returning to my willingness to take risks, I knew that those more traditional paths were not meant for me, making the decision a bit easier. With all those factors in mind, I would rank myself with a moderate to high capacity to take risks, which led me to gain the confidence to raise a traditional search fund.

Parting words

First, I mention that I view myself as a risk-averse person and then categorize my behavior in two ways that label me a moderate to high risk taker. Let me clarify briefly. Risk tolerance is in the eye of the beholder, but it also depends on the context of the situation. Since I do not see myself returning to a non-entrepreneurial career path given my interests, goals, and personality, pursuing a traditional search fund is one of the most risk-averse opportunities. A lot about risk is assessing and managing the downside outcomes, and we’d need another article to dive into risk management correctly. Yes, objectively speaking, being an entrepreneur naturally means more uncertainty and potentially much more downside financially and emotionally. However, when you compare buying an existing business with its alternatives (i.e., starting a new venture from an idea), search funds give us entrepreneurs a bit more downside protection from the unknown.

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I would love to hear your thoughts on my perspectives on risk. It may be an unorthodox view on the matter, but I think every one of us can push ourselves just a bit more.