Options
When in doubt, build a portfolio of options.
You no doubt understand now that it pays to be flexible when dealing with complex problems in unpredictable environments. But you do need to take some kind of action in order to survive and get your way. Both under- and over-investment in any given solution can be a disaster, especially when there's so much volatility in the world. How do you strike a profitable balance between investing too much, too little, too early, and too late?
One way to slice through this problem is to use the framework of options. Options give you the ability to make decisions in the face of uncertainty and even profit from volatility when the conditions are right. They're most famously known as derivatives traded on Wall Street, but the concepts built into options trading are applicable far beyond the realm of finance.
Real Options
Although there are many different types of options and ways to structure option trades, I'm only going to focus on a specific type of option from the world of corporate investing: real options. Real options represent a right, but not an obligation, to make an investment or take advantage of some kind of opportunity. When you have an option, you don't have to use it—but you can if and when you want to.
These options tend to be used in stages. This is allows you to gather discrete chunks of data based on performance and make subsequent adjustments. By acting in this way, over- and under-investing is avoided (at least in theory), which hedges away a lot of the risk. It also helps to balance the dilemma of early investing (which can potentially yield outsized results before competitors eat into them) vs flexibility (which can allow investors to better vet an opportunity and therefore avoid losing money).
Real options come in three primary flavors:
Expand: Invest more. This could be the initial investment, or it might involve putting more money in after certain milestones have been hit.
Abandon: Stop investing. If an opportunity turns out to be a dud, cut your losses and leave.
Defer: Wait to invest. The preferred option when you think there's potential in the future.
When an investor utilizes a real option, their loss is limited to whatever is invested at that time. Consider the example of a venture capitalist investing into an early stage startup. The process looks something like this:
Each round of financing represents a set of real options. Anytime a milestone is missed, the Review action is triggered and the investor can choose to expand, abandon or defer. This means they can control the risk of loss while balancing the resources they plow into any single investment.
You can expand this out into more complex processes, like that of a private equity company acquiring a platform of businesses:
At each stage, there's a clear success/failure signal that's used to make a decision about further investment (or abandonment/deferral). At the end of the process, you can see that real options have a recursive nature: when you acquire one option, it tends to open up other options in the future. That's part of why large-scale M&A tends to be so powerful in the business world.
Payoffs
Real options are similar to call options, which are financial instruments that are traded all over the world. The payoff diagram that looks like this:
When you buy (or "go long on") a call option, the risk you take is limited to whatever you spent to buy it. If the option cost you $100, you'll never lose more than that. Your breakeven comes when the option generates $100 of value, and anything over that is pure profit.
In the context of real options, the breakeven point represents where expansion decisions tend to be made. If the breakeven isn't reached, abandonment or deferral represent the most common options. The real option dynamic looks like this when imposed on an option payoff diagram:
You invest money, see where it goes, and if it fails then you're out what you put in. But if it starts to take off, you put more in as it continues to prosper. Set some milestones, and you can repeat this until you're either a billionaire or the investment dies.
Environmental Conditions
Real options are used in the analysis and valuation of companies, and the opposing framework is known as Discounted Cash Flow (DCF) analysis. DCF is used when there are stable conditions and more predictable cash flows. For example, if you're thinking about buying a factory that's been in operation for 30 years, you can extrapolate quite a bit on its value. This is particularly true if they have a monopoly or exist in an industry that doesn't change much.
DCF is inappropriate as a framework when working in more unpredictable environments, such as the early stages of a company's life. That's why real option analysis and its staged-investment style is popular in the world of venture capital: it provides a way to make intelligent investment decisions when you don't know what the future holds for an asset.
This carries over to any environment where you need to make decisions. The assumption throughout this book is that you're dealing with high levels of complexity, which means DCF-style methods are dangerous. There's simply not enough flexibility built into those types of strategies. Real options, on the other hand, are tailor-made for the real strategic conditions you deal with on a daily basis.
Heuristics
To be clear: real options represent a heuristic method. They involve guesswork and a particular vision on the part of the decision maker. You can absolutely get yourself in trouble using real options, just as you can create problems anytime your evaluation methods are wildly off the mark.
However, as discussed in the dilemmas section, heuristics tend to be the best way to navigate complex problem solving in unpredictable environments. These methods provide a way to gather data in real-time and make quick decisions that reflect the realities you're facing.
It's less reassuring than a big, complex plan, but it's also a relief: when you leverage options, you don't have to know the future to win. You'll have the flexibility to make decisions that leverage real data about what works and what doesn't. Isn't that a nice change of pace from stressing out all the time about the future?
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