Changing Attitudes About Risk & Loss

This past week saw the 25th anniversary of “Black Monday” or the market crash of October 19, 1987—a loss of value of 22.6 percent in one day. On Friday October 17, 1987 the market closed at 2246.71. On Monday October 19, 1987 the market closed at 1738.41 – a drop of over 508 points. A similar drop in value in today’s markets would see the Dow-Jones Industrials post a drop from the 13,343.51 close as of October 19, 2012 to about 10,328.

Just as some additional historical reference points, the market reached its historical high of 13,930.01 on October 31, 2007. On February 27, 2009 the market reached its most recent low of 7,062.93. A drop of something in excess of 49 percent. Ouch.

I remember exactly what I was doing on October 19, 1987. I was on a United Airlines flight from Chicago to Philadelphia for a meeting at Unisys’ headquarters. I was an Account Manager for Unisys on the Ameritech account. I was traveling with my boss at the time, a dear friend Jerry Parker.

As was typical, we were flying out of Chicago near the end of the day so that we could get to Blue Bell, PA for meetings the next morning. As we boarded the plane there was a noticeable “buzz” about what was going on in the market, but from my own personal perspective I can tell you that I didn’t have a worry in the world about what was going on in the markets that day. Oh, I had a little bit in a 401(k), but my financial world at the time was more about collecting a paycheck every two weeks and driving my commission checks as best I could.

So now let’s fast forward a bit to October of 2007. The market hit its historical high as indicated above. From October 2007 through February of 2009, I rode that “bad boy” all the way down. And I must say my own personal feelings were totally different from my 1987 experience. Now I was “in the market”, I had more at risk; I felt every 200 point drop in the Dow in my gut. I now had a feeling of what “risk” really meant. It wasn’t just some obscure theoretical concept relating to the cost of capital. Risk manifested itself as a real-world, declining net worth, and a future that was more uncertain every day.

I tell this story as perhaps nothing more than a personal reflection on how I process “risk”. But as appraisers, part of our job is to translate current economic and industry conditions and current prospects for a company into an estimate of risk – the cost of capital if you will. You see, in my mind measuring risk is more than just looking in the back of the current year’s SBBI, or Duff & Phelps Risk Premium Report (or whatever other information you are relying on). And sure, we can measure the volatility of similar companies and use that to help us estimate risk. But at the end of the day, there is more to measuring risk than what our data sources tell us about equity risk premiums and size premiums and the like.

I want to tell another story that I think also has some lessons for us as appraisers as we try to make estimates of risk for the companies that are the subjects of our engagements.

When I was much younger, I was faced with the decision of where to go to school. I had attended a Jesuit high school in Ohio, but really didn’t have two nickels to rub together. The local Jesuits suggested that I look at Loyola University of Chicago. Sounded good to me. I had an Aunt and Uncle who lived in Chicago. I dutifully sent along my application for admission to Loyola of Chicago, along with my $10 check. Several weeks later I received a “good” letter from Loyola.

The following fall I set off for Chicago and ended up at my Aunt and Uncle’s house in Chicago. Well, actually it was in Wilmette, which is about 20 miles north of Chicago’s loop and Loyola’s downtown campus. First surprise – how the heck am I going to get from Wilmette to the Chicago loop, every day?

Thanks goodness that Chicago has a terrific public transportation system. With help from my Aunt, we figured out that I could take a bus, to the 4th and Linden train station, change trains at Howard and then get off at Chicago and State and I’d be at Loyola.

At this point my decision to go to school in Chicago was looking a lot more difficult than I first imagined. Now I had to take a bus, to a train, to another train, and reverse this process every day to get back and forth from school (Loyola had few dorms in those days for out-of-state students like myself; it was and still is mostly a commuter school).

But being 17 has its advantages, and one is that you tend to be really resilient. So I headed off for the first day of “orientation” and as I got on the train, the instructions given to me were “just listen to the conductor and get off at Chicago and State”. Well, Chicago’s public transit system didn’t rely on Bose sound systems for its PA. I couldn’t understand the conductor to save my soul. But Chicago’s transit system was designed for people like me, who really don’t know where they are going. They put maps in each train car. Hoorah, I’m saved. I could read a map.

Anyway, I got off at Chicago and State and I’m looking around wondering, “well, where the heck is this Loyola place?” As it turns out, the “campus” was maybe 3-4 blocks away, and people in Chicago were pretty helpful to 17 year olds with dumb looks on their faces. Happy ending to the story is I got to Loyola and four years later graduate and I’m now a veteran of Chicago’s public transit system.

So what possible lessons can there be in the stories above for us as appraisers as we try to estimate risk? Well, let me try to tie things together here.

From my first story regarding the “crash” of 1987, here are my take-aways:

• If you are not in the market, there is no risk;
• If you have little to lose, you tend to discount the level of risk that you are facing;
• As a corollary to the above, those that have little to lose tend to bet big;
• If you have more at risk, you will feel it more viscerally, and you will probably have the resources to weather most storms that come your way.

From my second story regarding getting to Loyola:

• If you have a long runway ahead of you (life), early mistakes don’t carry as much weight as mistakes that you make later on, when the runway is shorter; it’s why entrepreneurs take on the un-godly levels of risk that they do and can still sleep at night;
• Sometimes it’s good to not know everything that maybe you should know; i.e., lack of information doesn’t always increase risk; if I had known every obstacle that I would face attending school in Chicago, I just might have stayed home;
• Good teams help to mitigate risk; obviously I got a lot of help from my Aunt and Uncle in getting to Chicago and Loyola and ultimately graduating; without their help I simply would not have been able to accomplish what I did; the same lesson holds true for businesses; companies with good teams should outperform companies with weaker or non-existent teams and be less “risky”;
• Young businesses and their owners tend to be resilient in working through un-anticipated problems; older businesses and their owners tend to have the experience to avoid these same un-anticipated problems (usually, not always).

While Black-Scholes models, and other option models, and studies of volatility can help us understand risk, qualitative assessments still have their place in our analysis. Rely on your own experiences when assessing risk in your engagements.

Rick Warner
Great Lakes Valuation