Life is uncertain and no one knows everything. Every single day, we are faced with choices or decisions without having at our disposal all the information that could influence the outcomes of these choices or decisions. Some of these decisions come with major risks that could have a substantial impact on the way the future is realised. Taking a calculated risk by quantifying these risks can help with the decision-making process. This is significantly more empowering that simply “closing your eyes and hoping for the best”.
The Cambridge Advanced Learner’s Dictionary defines a calculated risk as “a risk which you consider worth taking because the result, if it is successful, will be so good”.
So let’s see how you can go about deciding on taking a calculated risk.
The ability-to-sleep-at-night test
The following pointers will help you to quantify a risk:
- What is the description of the risk? Consider the external factors and your own previous endeavours. For example: If I start my own business, there is a risk that I will not sell enough of my products and not get enough income to make a profit.
- If the risk materialises, what is the size of the impact? In our example: If I do not make a profit, I will need to take money from my personal savings. Or: If I do not make a profit, I will not be able to support my family from my income.
- Does this impact matter to you and, if so, to what extent? This is where your priorities and values come into play. For example: I will not be able to support my family from my income. Or: We will have to cut down on our personal expenditure.
- If the impact matters to you, what can you do to counter the risk? I can make sure that I keep an alternative source of income while setting up my own business. Or: I can make sure that I have a bulk order before buying stock.
- What other safety nets do you need before taking this risk? As per our example: I need to have 6 months of income saved before I start my own business. Or: I need to make sure that I have that contract signed by that date.
- What else do I need to know that will help me to quantify the risk? As per our example: What would be the market appetite for the product I want to sell?
- Is there anything else that bothers me? Trusting your gut feel is also an important input to quantify the risk.
- What is the potential reward or return of this risk? I will be able to make a profit of R5 000 a month.
This ability-to-sleep-at-night test, also referred to as the iron-stomach test in the investment world, can help you to assess whether the potential reward is worthwhile when measured against risk.