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Understanding Risk in Strategy

Every Single Strategy Has Its Unique Risk

Start with understanding risk in an investment strategy

A business strategy tries to solve a set of problems to increase returns while minimizing risk. The return side is well-covered with numerous tools, analytics and frameworks to more or less accurately estimate free cash-flow, economic profit, NOPAT, enterprise value, EBITDA, net income, ROIC and any other return measure you use. Pick up any seminal textbook on strategy, valuation and corporate finance and the majority of calculations are about returns and growth. Take a moment to think about your own recent discussions on risk, the tools you used to measure risk and the frameworks you reference to understand risk. How helpful were they? With the exception of WACC, risk is often treated as a social science. We tend to rely on business judgement, gut feel and personal experiences to make decisions on risk. It need not be this way. Risk can be measured and calculated. The ability to visually depict the risk in a proposed strategy and the relative risk between strategy choices, opens a richer and deeper management discussion. That is what we will present in this section. To understand the risk in a business strategy, let’s begin with understanding risk in an investment strategy. Most of us would intuitively grasp the concept when used in the world of investment and retirement planning.

Portfolio 1

Would you feel comfortable if your entire investment portfolio consisted of only one asset, for example, Apple stock? This means you have no other stock, no cash, no bonds, no property, no crypto, etc. You have nothing else. Most investors would be very uncomfortable doing this and it’s hard to imagine an investment advisor endorsing this plan. In this example, all the returns from your investment portfolio move in the same direction because they are all the same stock. When the price of one Apple share goes up 1.2%, they all go up 1.2%; when it drops 0.18%, they all drop 0.18%. When the returns from all your investment assets move in the same direction, we say they are correlated and they are not diversified. This lack of diversification worsens when the returns from the assets move in the same direction by the same amount, and at the same time. This is a perfect correlation. It is the most risk you can have in your portfolio. Investment finance has the tools to measure the risk and expected returns from this portfolio.

Portfolio 2

Let’s assume it’s the same portfolio of Apple shares, but you’ve now decided to also own Microsoft shares. They are different companies operating in different product markets with different business models and different risks. Yet, they are broadly seen as technology companies and because they are based in the US, they are subject to the same technology laws. Therefore, their share prices often move in a similar direction most of the time. Since a Microsoft share and an Apple share often move in the same direction at roughly the same time, even if not by the same amounts, we can say there is not much diversification in this portfolio. Adding more Microsoft stock to the portfolio does not change the risk much, though it may change the returns. We can also measure the risk and expected returns from this investment portfolio.

Portfolio 3

You have decided to keep your Apple shares, sell your Microsoft shares, and buy shares in Airbus. They are very different companies. It is unlikely investors treat them the same. Therefore, the risks that drive Apple shares lower are unlikely to have the same impact on Airbus shares. In fact, the risks that drive down the price of Apple sales, its future cash flows, and finally its share price, could cause Airbus to be seen as more attractive and drive up its share price. Therefore, Apple and Airbus shares do not move in the same direction. Losses in Apple are offset by gains in Airbus. We can measure if asset returns are correlated and no guesswork  is required. The shares are counter-correlated, but we don’t know yet if this portfolio is diversified. If 99% of the shares in our new portfolio are Apple and 1% are Airbus, the gains in Airbus will not be sufficiently large to offset the losses in Apple. Only once our portfolio holds enough Airbus shares to offset our Apple losses can we say the portfolio is diversified. Different investors will often seek different levels of diversification. Some may not want a perfectly balanced hedge. They often believe they are smart enough to read the market and rebalance their portfolio in time.

Do you see the difference between Portfolios 2 and 3?

Would you prefer Portfolio 4?

In our example, we need more of the portfolio to hold Airbus shares. We can work out the approximate ideal split to perfectly hedge our losses. Let’s assume the ideal split is approximately 43% Apple and 57% Airbus. This split will change as the economics of each company changes. Yet, if we changed the portfolio by continuing to add more and more Airbus shares, going from 57% to 67% to 77% to 81% to 88% to 99%, we end up with a similar situation as before, but in reverse. Now, any increase in Apple shares will not be sufficient to offset the losses in Airbus shares because we own too little Apple shares. Diversification is not just holding assets whose returns move in opposite directions, but we must hold the appropriate amounts of each to balance out likely losses.

Therefore, there are four levers in diversification:

  1. Do they move in the same direction (correlation);
  2. Do they move at the same time (synchronicity);
  3. How much do they move (activity); and
  4. The percent of the asset you choose to have in your portfolio to achieve the level of diversification you desire (balance).

Portfolio 4

Now that you understand diversification, you’ve decided not to have your investments in just two companies, exposed to two currencies and mainly two countries. You’ve decided to split your investment portfolio across 20 assets. They are spread across countries, currencies, developed and emerging markets, industries, growth and value stocks, dividend-paying and non-dividend-paying stock, bonds, tax regimes, inflation rates, property, cash and gold. Most importantly, your investment advisor has done the calculations to show you the expected returns and likely risk. You know your portfolio is diversified because when everything is netted out, losses from one part of your portfolio are expected to be offset by gains in another part of your portfolio.

Everything we discussed so far, is investment advisory work, even if people do not follow this advice. Most people will have the majority of their investment portfolio either in stock in the same market, like the USA, and often in the same currency, like the dollar. This is not diversification. You will know you are diversified when your overall portfolio does not suffer extreme losses. If this happens, it’s important to ask tough questions to your investment advisor. The goal of using an investment advisor or wealth manager is to avoid building a portfolio that is not diversified. If your investment portfolio is performing the same as an investor who does not use an investment advisor, you may need to reconsider your advisor.

What are your current goals and your strategy to achieve it?

Let’s assume you have $5,000,000 to build your investment portfolio and you want to earn $100,000 in dividends per annum. This means your dividend yield is equal to 2%.

There are many companies that pay a dividend. Therefore, you have a lot of options to assemble that portfolio. You could assemble three different portfolios that would each likely generate a 2% dividend yield. Let’s call them Dividend Portfolio (DP) 1, 2, and 3.

We know that within each portfolio the returns from each asset may or may not:

  1. move in the same direction,
  2. move at the same time, and
  3. move by the same amount.

Therefore, the risks are different. You can see the permutations and combinations get a little mentally tiring. You do not need to do the math in your head. To understand the risk in a strategy, all you need to remember is that DP1, DP2 and DP3 may all satisfy your goal of a 2% dividend yield, but their risks will be very different. For example, DP1 may all be energy stocks. They tend to pay high dividends but they move together. If the energy prices fall, all their prices will fall and they may all cancel their dividends. DP2 may be a mix of stocks for different industries and countries. It is unlikely they will all stop paying dividends at the same time. It’s even possible that when some stocks in DP2 lower their dividends, others will increase their dividends.

When you, as a typical investor thinks about risk, you often do not think about all of the risks

There are two big risks involved:

Risk 1

First, is the risk we previously discussed. That is the risk that all the returns from your assets move in the same direction, at the same time and by the same amount. If that happens, you have no diversification. Most investors will understand this risk. You will also realize that different portfolios of investments, like DP1, DP2 and DP3, can have different changes in share prices and dividends (the return) and different risks (degree to which asset returns move in the same direction, at the same time and by the same amount) when producing the same outcome like a 2% dividend yield. Every investor has a goal. In this example the 2% dividend yield is the goal and the investment portfolio is the strategy to achieve the goal. As you can see, more than one strategy can achieve the goal, but the strategies will expose you to different risks.

Risk 2

There is the second risk, which we often do not think about. When you physically want to complete the purchase of assets to include in your portfolio, you rarely worry if you will be able to do it. You believe that you can make the purchase or sell a share to build your ideal portfolio, when you want to do it. Those who actively manage their  portfolios know this to be untrue at times. In the simplest example, if Tesla shares fall to $2 a share, giving you a tremendous opportunity to buy in low, it may take several hours for your funds to transfer from your bank account to your Robinhood account, and be cleared by Robinhood. If the price crashes are outside the typical working hours of your brokerage firm or investment advisor, they may only execute the trade the next morning. By that time Tesla shares may have bounced back and the opportunity is lost. The same is true if you are trying to sell before the value of an asset drops. We call this the risk of being able to build your investment portfolio. It is the risk of implementation.

Even if your strategy is successfully implemented, there are still risks

Any investment portfolio you plan to build and maintain has two primary risks. First, is the risk of being able to build your investment portfolio. Second, is the risk within the portfolio you have built, and different portfolios will have different risks and returns. Even if you completely eliminated the risk of building your investment portfolio, the second risk is always there. You may be wondering what this has to do with risk in corporate strategy. When companies develop a corporate or business unit strategy, they often focus on the risk of implementation, the first risk, and ignore the second risk. Most companies assume if they overcome the risk of implementation, there are no more risks. In our experience the majority of companies do not know the risk of their chosen strategy, nor do they know the relative risk between all their strategic choices.

The risk of a strategy can be significant even if the strategy is perfectly executed.
This is the big insight and blind spot in strategy and planning.

In keeping with our first example, if you are able to buy Apple shares exactly when you wanted to, this would not eliminate the risk of having zero diversification. In fact, the ability to routinely execute your plan simply concentrates more capital in a risky strategy. The fall, when it comes, will only be more painful.

Companies must be able to understand the risk of their strategy,
especially after it has been perfectly executed.

What is the unique risk in each strategy?

Company A, a resources giant, is pursuing a revenue target of $30 billion and a net income margin target of approximately 5%, within the next five years. The CEO is considering two strategies; Strategy One = stick to iron ore and buy up iron ore competitors. Strategy Two = branch into gas and phosphates used in fertilizer, from its iron ore base. The company hires a team of bankers and management consultants to plot out and analyze both strategies. They find acquisition targets, and project their revenues, margins and operating efficiencies. Each commodity can be thought of as each asset in your investment portfolio. Therefore, iron ore, gas and phosphates comprise all the assets in Company A’s asset portfolio for Strategy Two. Iron would be the only asset in Company A’s asset portfolio if it pursues Strategy One. Let’s assume there  is absolute certainty that they can implement both strategies. In other words, for the purposes of this example, the implementation risk is zero. Let’s also assume that they can get to $30 billion revenue and 5% net income margin within five years with both strategies. Some would say the strategies are the same. They are not. The changes in the free cash flow (returns) and the risk (degree to which asset returns move in the same direction, at the same time and by the same amount) will be radically different between both strategies.

Strategy One has no diversification. That risk can be measured. The potential free cash flow, the returns, can be measured.

Strategy Two may lead to diversification, or it may not. We will not know until we calculate if gas, phosphate and iron ore prices move in the same direction, at the same time and by the amount they move. Let’s assume they move in opposite directions, at the same time and by the same amounts. That is good news, but it is not yet diversification. Company A needs to buy large enough gas and phosphate businesses to sell enough gas and phosphate to offset any decreases in iron ore prices, and vice versa. This can be calculated for any strategy and it should be shared and debated before a strategy is implemented. It can be done for any company and industry.

Yet, why are they only considering gas and phosphate? Why not consider oil, cement, paper, etc. In other words, they can get to $30 billion in revenue and 5% net income margin by buying into different new industries and by different amounts. How do they decide what to do? We can depict this using a visual aid that transforms board and management discussions. Many companies can often achieve the same return by taking on less risk. This is one of the useful insights from this lens.

We can now give the board of directors a very practical and useful map of their options, which often becomes their primary discussion tool

Understanding Risk in Strategy 1

  • A dot represents a different strategy to achieve a goal.
  • The goal is the same for each dot.
  • A dot is a portfolio of different assets that could achieve the goal.
  • The degree to which free cash-flow, our proxy for returns, between the assets in each dot moves in the same direction, at the same time and by the same amount is called the risk.
  • Each strategy to achieve the same goal can now be plotted, compared and debated.
  • It is often useful to zoom into a dot to understand why it is more or less risky.
  • Risk tolerance and risk appetite, often discussed separately as corporate finance issues, can be analyzed from a strategy perspective.
  • The same analyses could be run on costs. We could, for example, understand the impact of diversifying the energy cost base of oil, coal, gas and diesel power a country. This analyses would show the benefit of adding renewable energy to the mix.

Using this depiction, at least once a year any board should be asking the following questions;

  1. What is our goal?
  2. What is our proposed strategy to reach our goal?
  3. What are the return and risk differences between our current strategy and proposed strategy?
  4. How does the proposed strategy compare to other strategies to achieve our goal?
  5. If we had to make a trade-off, do we prioritize returns or risk?
  6. Does the proposed strategy create the maximum return possible for that level of risk?
  7. Does the proposed strategy expose us to the lowest possible risk for that return?
  8. Is the strategy within our risk appetite and are we reasonably confident of our projections?
  9. What should be diversified? (returns, customers, products, markets etc.)
  10. Many of the answers to these and other critical questions can be visually depicted. The impact of the differences in the numbers are often better understood visually, as the two examples below illustrate.

Is the risk of buying our largest iron ore competitor worth the return?

Understanding Risk in Strategy 1

It’s not necessary to be precise with the answers, yet it is important to understand the direction in which the company is going and understand the trade-offs. In addition, the typical considerations like synergy and barriers to entry need to be considered. Yet, it’s often the case that the traditional considerations are the only ones discussed.

There are multiple ways to unpack this

This approach introduces an additional executive-level framing of the problem. It is not recommending that all companies should be diversified across products and industries. There is a sufficient and compelling body of work arguing that investors should be diversified and not companies. Indeed, many companies lose focus when they diversify. There is indeed a strong case for specialization when it makes sense. Yet, every board can only benefit from visually understanding the true return and risk of their chosen strategy to meet their goal. Companies choose to ignore product diversification and diversify in other ways to to gain similar benefits.

One client, for example, spent two full days debating the chart in a workshop that we facilitated. In the end, they decided to remain a single-product business. Yet, they now could put a value to the benefit of diversification and that encouraged them to act.

  • First, they reduced their exposure to the US market, and English-speaking markets in general.
  • Second, they moved production plants around the world to mitigate supply chains costs and risks.
  • Third, they courted major new customers in new markets.
  • Fourth, they started accepting payments in other currencies.
  • Fifth, they introduced new product variations suited to specific local markets.
  • Sixth, they expanded their sales channels and launched premium version of their products.

Their goal was to avoid being exposed to only one direction of macroeconomic trends like interest rates, inflation and exchange rates, and geopolitical trends. This strategy proved itself over the last few years as supply shocks and market closures could not overcome the hedges they had built. Once you know the risks and returns from your strategy, it provides a powerful way to think about defending your business.


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