Risk Analysis 101: What's Your Tolerance for Investing in Collectibles?

Life is a long series of decisions, made one after the other, having ramifications; costs; gains. Knowing what decision to make - and more so which decision is best - can be tricky, cumbersome, and crippling. A fantastic but oft-overlooked tool in decision making, especially regarding business, is risk analysis.

Risk analysis is something that comes naturally. We use our brains to weigh the outcomes of a decision, eventually arriving at a level of risk that's palatable to us. However, what comes less naturally is making this process systemic and putting pen to paper. Taking these two steps can push risk analysis from being a somewhat haphazard practice occurring entirely in the mind towards standardization, allowing for more consistent decision making in full consideration of what is at stake.

Condensed to its essence, risk analysis is a three-part process: risk assessment, management, and communication. The first part, risk assessment, is something the average person encounters every day but generally spends little time pondering. The second part - risk management - occurs more over time and in the wake of a decision. The final part, risk communication, is typically only necessary when stakeholders are involved. In other words, when a decision may affect more than one person, risk communication is key.  A famous example of this process in action (read: at least in the world of sports) was dramatized in the 2011 film Moneyball. The new general manager (GM) of the Oakland A's, with the help of a statistician, builds a winning baseball team by bucking the trend of relying almost exclusively on scouts' picks and reports, in favor of seeing which players were top performers and affordably priced. To bring it back to risk analysis, the new GM:

  • assessed his risk using a statistical approach to find bargains
  • managed his risk by committing fully to the new system, and
  • communicated it to his stakeholders in a manner that would probably rub most people wrong!

From a business perspective, no single person should be solely responsible for all three parts of risk analysis. A lot of fantastic reasons exist for this, but putting it simply hammers it home best: enshrining this process with a single person places a company at tremendous risk, and it's damn stressful for the person responsible! Much like investing, diversification is king. Therefore, in a perfect world, each part of risk analysis occurs in a vacuum. In other words, the risk assessors, managers, and communicators are able to complete their responsibility without influence or input from one another. In reality, this is rarely the case. As stated before, risk analysis comes naturally, so it can be difficult to insulate outside bias. For example, a risk assessor may complete his part of the process and submit it to a risk manager to review. But, risk managers are people, too. Thus, the risk manager may review the risk assessment and decide it wasn't done correctly and do an assessment of his own, disrupting the desired separation of processes.

I could spend a lot of time talking about risk management and communication; however, the most "bang for your buck" change any company can make is building a habit of doing high-quality risk assessments. A risk assessment's chief value is going to be when trying to make decisions about whether an investible asset is worth the potential risk (i.e., is the juice worth the squeeze). The risk a company takes on when deciding on investible assets is multifaceted. For example, assume that your business - Happy Hobby Shops - has $500 of capital to invest in assets. You can buy two investable assets - Asset A and Asset B. Your risk can be neatly chunked into a few categories, bearing in mind that this is an example and the following is not exhaustive:

  • Opportunity cost (i.e., if we buy Asset A rather than Asset B, what will we miss out on if we didn't pick Asset A)
  • Failure to appreciate (i.e., if we buy Asset A and its value never increases - or it loses value - then we're out $500 of capital)
  • Decision freeze (i.e., if we make no choice, your money isn't working for you - or perhaps neither Asset A nor B is available when you finally reach a decision)

By conducting a risk assessment, a company can install a process to attempt to quantify these risks and make a logical decision. A lot of methods exist for doing so, but for most companies, it's probably best to start simple.

A simple risk assessment method would be to assign a numerical value to potential risk and then define it. For instance, assigning a value of "1" to low risk and a value of "3" to high risk allows you to make this process mathematical. Next, you can define some categories on which you want to assess your risk. Let's go back to our example of Assets A and B. Since this article is appearing on a website focused on fantasy/science fiction art and memorabilia, some potential risk categories might be:

  • Popularity (i.e., is the asset from a popular and well-known franchise or intellectual property, or is it from a more subculturally popular realm?)
  • Timeliness (i.e., is now a good time to buy the asset? Has some external circumstance driven costs up, such as the recent death of an artist?)
  • Opportunity (i.e., will we have another opportunity to purchase this asset in the future? Is it one of a kind?)

By setting up a handful of categories like this, you can start to assign risk values to your options. The easiest way to envisage this is to show an example of how we approach this problem at Vault of Alexandria.

DISCLAIMER: this is a hypothetical example for educational purposes only. Additionally, the below example is a bit like assessing whether to buy a Honda or a Maserati. In reality, both have their place but drastically different purposes.

example assessment table

Putting your risk assessment into a spreadsheet is advisable. Walking through the example above, we've presented two investible assets; an original art piece and a graded copy of a video game - vastly different price points. Using the categories we defined earlier, it's time to further define them. This will help us make the process more objective as well as opening the potential to be quantitative about our decision-making process.

 It's important to spend enough time to clearly define risk assessment values. Ideally, in each category, risk assessment values should be mutually exclusive; in other words, you shouldn't be compelled to assign a 1 or a 2 in any given category and instead should know exactly which one to assign, based on the definitions.

So, let's walk through the example from before. Goldeneye 007 is a video game for the Nintendo 64 console, released in 1997. Some cursory Internet research tells us that the game sold over 8 million copies. This was over 20 years ago; however, that's still a large volume. The game is fairly old at this point, meaning inevitably some of these cartridges were simply lost to time. A VGA (i.e., Video Game Authority) graded copy is decidedly rarer because collectors aren't looking to pay money for grading service unless the item to be graded is in fantastic condition. That pushes this from a 1 to a 2 in Opportunity. In Popularity, additional research shows that this was one of the top-selling games for the Nintendo 64, a decidedly popular console in its day and continuing to the present. This was a licensed video game adaptation of a "James Bond" film; while James Bond is a popular franchise, in the context of the item itself, James Bond video games are decidedly more of a niche interest. As such, Goldeneye 007 scores a 3 for Popularity. Moving on to Timeliness, it's important to do some market research when evaluating a category like this. A lot of platforms exist for doing this type of research, but generally, it's advisable to conduct the search within the marketplace you're hoping to sell the item. In this case, eBay is the most likely place we try to sell. Again, a quick search reveals a single sale in the last month for a similar item. As such, this isn't a fast mover when considering the other categories we've already assessed. Initially, assigning this a score of 3 is tempting, but re-reading our definitions pushes it closer to a 2 (which is what it was assigned in the final review).

The above example gives a picture of the potential thought process behind assessing the risk of a given investible asset. In the final column, Target Value is simply the product of the other categories. We'll use this aggregate to ballpark the urgency or value we should place on the asset.

Without going through a long-winded explanation of my valuation of the "Azban Battle-Priest" by the incredible Chris Rahn, the example assessment above shows that it came out on top in Target Value. Applying a critical light to this, it tracks with what is generally reasonable investment advice: dollar for dollar, paying for quality pays dividends. In the case of this piece, it's a one of a kind original artwork from a popular card game. When compared with a mass produced (albeit, high quality) video game, it's generally going to be a better investment vehicle. Chris Rahn simply isn't making more "Azban Battle-Priest" paintings at this time, and there's only one original.

Concluding, risk analysis is a powerful tool in our decision-making toolbox. When thoughtfully applied, it can help us make more objective and data-driven decisions. In a world where a business owner is confronted with tons of tough choices on a regular basis, we need all the tools we can get to make our lives easier - and more importantly, stave off decision freeze! Happy risk analyzing, y'all.