Risk as a source of profit

I’m reading Aswath Damodaran’s book Strategic Risk Taking: A Framework for Risk Management and I’ve been blogging about it from time to time as I chew through the concepts.

In chapter 4 of his book, Damodaran talks about how, in the nineteenth century, the idea of risk changed. Risk was once thought of as a function of loss (which is why we have insurance) but then it changed and risk became a source of profit (which prompted investors to create various statistical risk measures).

The idea of risk as a source of profit has been a rock in my shoe. I can’t get the thought out of my head.

A FEW WAYS THAT BUSINESSES PROFIT FROM RISK

It strikes me that all business profit from risk in many different ways:

First, businesses profit from risk by buying raw materials at a low price and then selling finished products at a higher price. They risk raw material prices going up and they risk that their finished products will have pricing pressure to cost less. They minimize this risk by negotiating for lower raw material costs and by periodically raising the prices of finished products.

Second, businesses profit from risk by hoping that people need their products and services. Here’s an example: People used to get where they needed to go by foot or by horse. Ford (and others) took the risk that people would want to get somewhere faster and a little more comfortably so they built a car. Here’s another example: Businesses could probably hire people to perform various functions and tasks but software companies took the risk that those same functions and tasks could be automated to free up staff for other purposes. Here’s another example: People could always make their own food but McDonalds took the risk that sometimes people would not want to cook but they would want something fast and affordable that they can eat on the go. Businesses minimize this risk by doing market research first and by making mid-course adjustments based on customers feedback.

Third, businesses profit from risk by competing with other businesses. They bring a slightly different business to market and hope that their offering is more attractive to customers than their competitors’ offerings (and they hope that another competitor doesn’t come along and out-do them). Businesses minimize these risks by targeting a narrow market, providing a ton of value, and marketing like crazy.

Fourth, businesses profit from risk by hiring staff to do the work that will collectively result in a product or service being delivered. The risk is that they’ll find enough employees to hire affordably, and that even on unproductive days, those employees will still collectively do enough work to deliver what the business promised. Businesses minimize these risk with hiring practices, training, incentives and perks, human resources departments, employee reviews, and more.

Fifth, businesses do all of this in an environment that risks running unprofitably because of inflation or litigation or government regulations (and more). Businesses minimize these risks with investing and expansion, lobbying, insurance, and more.

As I write this, I realize I could go on and on. There are many of ways that businesses accept risk to earn a profit.

WHAT ABOUT FOR YOUR BUSINESS?

If you run a business, you accept the risks in order to earn a profit. Ultimately, you are risking the possibility that people will try to do something themselves instead of getting you to do it for them.

And if you think “They couldn’t do this themselves”, you’re kidding yourself — which is exactly why financial advisors and real estate professionals are facing industry-changing competition from DIY options.

Every consumer has a do-it-yourself option for everything in their life (from health to food to finances to legal to transportation to employment — you name it!). Your job as a business owner or professional is to “take on the risk” and make your product or service so awesome that the customer immediately sees that their DIY option as the riskier (costlier and more time consuming and failure-fraught) choice.

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