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David Seto's Column: Financial Risk and the Braggart

It's usually entertaining to listen to CEOs pitch their companies. They can be so passionate. But sometimes, after a 45 minute, non-stop, self-absorbed monologue, you really have to wonder about the soundness of their business plans.

Take a recent meeting where a CEO wanted my input on how his firm could obtain overseas investment financing. The initial 15 minutes were fine: a clean description of what his firm does to generate revenues and profits. His idea was cutting-edged and described a service that few have considered. The initial investment capital was significant, and his contacts were impressive. He even brought along a newspaper which featured some news coverage about his work.

But in the subsequent 30 minutes, he began to repeat himself and committed the sin of all sins: he began bragging. He asserted his company's first few years of profit growth, already at triple-digit levels, would only accelerate in subsequent years. News coverage would extend well beyond China to the world's media. Support would come from all governmental levels.

There's nothing wrong with bragging per se. But in the world of finance, it comes at a cost. Entrepreneurs must understand that professional investors -- like venture capital firms -- aside from being perversely cynical at a fundamental level, operate on a basic assumption: higher risks accompany higher returns. Hence, the more a CEO brags the more an investor expects to see things go wrong, or right, as the case may be.

In fact, the financial world has been able to quantify risk for some time now. Many tools exist, but the most basic comes from the field of statistics: standard deviation. It's not a perfect tool, but it does provide a starting point for investment analysis. The basic theory is that any investment, over time, will result in a series of investment returns that are distributed over a range. From this range, you can calculate the average, as well as the standard deviation which measures the degree of the dispersion of risk throughout that range. As Table 1 shows, the higher the return, the higher the standard deviation - hence the higher the risk - there is likely to be with most investments. The key is to find an investor who not only likes the expected return of the investment, but who can also accept the possibility of a wide range of returns that can be largely positive as well as largely negative.

After I informed the newly acquainted CEO of these concepts, he did me a big favour; he stopped bragging.

Writing on finance and economics for the last 17 years, David Seto, CFA, splits his time between Hong Kong and Beijing where he reads Chinese classics and tries to revive his defunct band, Scarbelly. Any comments on his columns can be sent to dseto@btmbeijing.com.