Red-Blooded Risk: The Secret History of Wall Street

Risk

So far we have not discussed risk. Let's go back to that second step, when the potter's growth rate was 50 percent. It won't be the case that the potter knows the gross profit margin at the beginning of the business, and it will change over time. It will not be a steady 50 percent per pot. Some pots will be failures—100 percent loss. Others may fetch three or five times their cost. There will be unpredictable interruptions in supply and demand, and unexpected surges in both of those as well. Without money, the potter cannot manage these risks, which means he cannot take advantage of exponential growth. He can only guess what scale of operation is optimal. If he guesses wrong, or perhaps even if he guesses right, the entire enterprise collapses. He needs money to “carry over” good luck. If he happens to have a successful period, he can grow the operation at a prudent rate and bank some surplus. In bad times, he can scale back the operation and dip into surplus. Without money, he will have to make much more violent and inefficient changes in scale, and he will be unable to compute the proper strategy. The business might not survive, even though it has the potential for a 50 percent growth rate, or it might be run so conservatively that it never grows or innovates.

What does the potter need to carry over luck? For one, he needs a store of value. Unsold pots are his only option without money, and they take a lot of room to store and have zero yield. He needs to be able to use ...