Investing Concepts 101: A Discussion of Risk
While investing in web properties is a relatively new phenomenon, the idea of investing itself has existed for at least a few centuries. For this reason, we’re going to be putting out a series of posts about basic investing concepts and how they apply to investing in web properties.
Today we’re going to be discussing Risk (the concept, not the board game). While traditional investing and website investing require a slightly different set of skills (e.g reading a business’s 10K vs. reading a website’s Google analytics data), there are a lot of parallels between the two when it comes to the way you should think about and assess risk.
If you haven’t read our two part guide to Buying and Selling Websites, I highly recommend you do so. We’re going to use some concepts and terms that we’ve discussed previously, so be sure to check those out if you haven’t already. Here’s Part I and Part II.
Ok. Time to Dive into some Investing Concepts:
The Concept of Risk
This is one of the most basic concepts in the investing world, and it’s definitely one of the most debated. There are essentially two schools of thought.
One half of the investing world believes in the old adage ‘No Risk, No Return’ – basically, that markets are more or less efficient, and that it’s impossible to get excellent returns without taking on an equivalently large amount of risk.
The other school of thought is that it is possible to achieve outstanding returns without a corresponding increase in risk – that it is possible for smart people who are willing to put in the work to beat the market. I fall into this category – and if you’re reading this post, I’m assuming you do too.
I firmly believe that it’s possible to achieve an excellent return on investment if you approach your investing in a smart, disciplined manner and you put in the work to find exploit market inefficiencies. If you don’t agree, you can take it up with Warren Buffett, Benjamin Graham, or any of a few dozen other well known investors who’ve consistently earned outsized returns over the long run.
Not only do these two ‘schools’ in the investing world disagree on market efficiency – they differ on the very nature of risk itself. The former group believes that risk is measurable with statistics – that it can be boiled down into a single number that measures the volatility of a stock (or financial product).
The latter group believes that the risks of an investment directly relate to the risk in the underlying asset (e.g the risk of buying stock in a company that sells coffee is that at some point this company will sell less coffee). Again, I fall squarely into this camp, and as such I will be discussing the ‘risks’ of website investments in these terms.
I’d advise you to think carefully about what you believe when it comes to investing. If you don’t believe that it’s possible (in the long run) to earn higher-than-average investment returns without taking on higher-than-average risk, then I’d honestly advise you not to invest in websites at all. People who have the worldview that they can’t achieve better than average returns often end up not putting in the necessary work (because they see it as pointless) – and it basically becomes a self-fulfilling prophecy.
Risk and Web Properties
The great stock market investors of our time believe that the risk of investing in a stock is essentially equivalent to the risk of investing in the underlying business. When it comes to web properties, the two are exactly the same – there’s no separation between you and the website. Buying a website is less like buying shares in a company – it’s more like buying a whole business.
For example – let’s say you were buying a car wash. You would probably want to (at the very least) know the following:
- How much business the car wash is doing
- Whether the revenues/profits/number of customers are growing or declining
- Whether the car wash has a good or bad reputation in the neighborhood
- How many other car washes there are in the area and how they are doing
- Whether all the accounting/legal paperwork is in order or not
- What assets the carwash business comes with
Basically, you wouldn’t buy something like a carwash or a laundromat on a whim. The same thing applies to websites, just on a smaller scale. Essentially, risk can more or less be boiled down into the following 7 categories:
- Competition Risk
- Risk from Customers
- Management Risk/Internal Risk
- Risk from Suppliers
- Industry Risks
- Regulatory Risk
- Wider Economic Risks
- Risk of Fraud
Success or failure for any kind of investor comes down to the ability to assess risk in a disciplined, unbiased manner and weigh that against the potential return. Risk vs Reward – it really is that simple. It’s what separates someone like Buffett from the millions of people who lose money in the stock market each year. It’s the reason why Mark Cuban became a billionaire when thousands of others lost their shirts in the tech bubble crash.
Understanding risk is vital. As such, I want you to do a little exercise for me – to make sure you understand what the risks are when it comes to website investing. Take a few minutes, and map out how each of the 7 risks I mentioned above relate specifically to web properties. I’m going to do the same thing for myself below – but you should try it for yourself before reading any further.
Done?
Competition Risk
This is the risk from your competition. But don’t mistake this as just risk from other similar websites. A site about coffee machines relying on affiliate links to make money isn’t just competing against other sites. It’s also competing against:
- Any site that is competing for rankings in the same KWs in the SERPS, regardless of how that site is monetized (via ads, affiliate, dropshipping, ecommerce, lead gen etc)
- Any business that is competing for the same Paid traffic (in the form of Adwords or on other Ad networks)
- Any business (even Brick & Mortar) that is taking away potential affiliate commissions from the site
- Any site that is a selling/marketing any substitute products for the ones that you make money from (e.g A site that markets french-press coffee as opposed to coffee machines)
The competition for any given web property is unique to its circumstances – a site like Grantland is competing more with the New York Times than it is with the average dingy sports blog, even though the formats of the two are very dissimilar. Think carefully about the potential sources of risk from your competition.
Risk from Customers
When it comes to web properties, customer risk is a real area of concern, particularly if you’re relying on organic traffic from search engines. Google rankings (or rankings in other search engines) can change overnight – either because other sites have better SEO, or because of Algo updates or penalties. It’s equivalent to owning a store that’s located on a road that can be closed/blocked off at any time without any advance warning. Websites that rely on paid traffic fare better, but there’s still the risk that you can be outbid and lose your traffic (and thus potential customers). When thinking about customer risk, the most important thing to consider is the stickiness of your customers. Stickiness is basically how easy it is for a customer to stop using your website. A site that relies on organic traffic alone has low stickiness; a site that uses paid traffic has medium stickiness. A site that has a dedicated following in the form of a large email list and a strong social following has high stickiness. Websites that offer monthly subscriptions are stickier than sites that offer one-off products. Sites that have amazing content are stickier than sites that have mediocre content.
When you’re buying a website, think about how sticky the current customer base is, and more importantly, think about potential ways to improve stickiness. In the long run, a store with dedicated, repeat customers will be more successful than store that relies on foot traffic and walk-ins. The same principle applies when it comes to websites and online services.
Management Risk/Internal Risk
This one is pretty simple. If you were buying a stock, you’d want to look into the management of the business and whether or not they have the correct experience/skill-set for managing that business. When it comes to web investing, the management team basically consists of you (and anybody you hire to manage the site). So you need to think about what your own experience and set of skills are suitable for managing the website that you’re buying.
Risk from Suppliers
Don’t get this confused. If you’re making money from Google Adsense, your supplier isn’t the Ad Buyer – it’s Google. The same applies to Amazon. If you make money from Amazon Affiliates by marketing ABC brand coffee machines, the supplier isn’t the ABC company – it’s Amazon. There are two things to consider when it comes to suppliers:
- Supplier risk of failure – how likely is it that your supplier suddenly closes shop/disappears? This can happen when you’re a part of smaller affiliate programs, or if you’re dropshipping via a factory in China or something similar.
- Supplier power – how much leverage do you have with the supplier (and vice versa)? You have no leverage when it comes to working with Amazon, Google, or any other large Ad/Affiliate network. The profits you contribute to these businesses is a drop in the bucket. If Google decides to ban you site from Adsense, or if Amazon decides tomorrow that commissions will be cut in half, you really have no power to negotiate. The smaller your supplier (and the larger % of their business you take up), the more likely it is that you can negotiate terms to your advantage.
The two concepts above are in direct opposition with each other – the larger the supplier, the more power they have, but the less likely they are to fail. You should try to strike a balance between the two – don’t work with shoddy affiliates that are untrustworthy and that frequently pay out late. On the other hand, you should try to find ad/affiliate suppliers that can provide you with better terms (CPC, commissions, dropshipping prices, etc) than you’ll find on Google/Amazon and the other super-large suppliers.
Industry Risks
This is the ‘bigger picture’ risk (and potentially, the reward). Will the niche of your site see an uptick or a trend downwards? Will people stop buying traditional coffee machines in favor of capsule machines or french presses? Or will people switch to tea?
More importantly, how resilient is your site to these kinds of changes? A site called ‘caffeinelovers.com’ has a better chance of responding to industry trends than a site called ‘besthomedripcoffeemachine.com’. How specific is your site? Could the nature of the site be broadened?
Beyond just the popularity of the product itself, you should also consider the method which your site makes money. By owning a website, you’re by definition not only in the industry that relates to your niche – you’re also in the ‘website’ industry. If a particular affiliate program becomes unavailable, how possible is it for your website to pivot to a new affiliate program? Or a new monetization method entirely? Can your affiliate site be changed into an ecommerce or dropshipping store? Can you fall-back on traditional ads and still make money?
All these factors should be taken into account when thinking about industry risks. The more flexible the domain/content/monetization of a site is, the better. Flexibility allows for greater resiliency when an industry undergoes changes. It also gives you more room to capitalize on new trends.
Regulatory Risk
This one is simple. If your domain contains the name of an established brand or company, then there is regulatory risk. If your site contains copyrighted images or content, then there is a regulatory risk. If your site provides a services that is potentially illegal (e.g filesharing/illegal streaming/software download sites), then that is a very real regulatory risk. Generally speaking, we advise you to avoid all of the above. Regulatory risks are particularly unpredictable, and the consequences can be quite drastic, so tread warily if you’re thinking about buying a site that isn’t on the straight and narrow.
Wider Economic Risks
How recession proof is your business? You might think that this is a silly question when considering a website – but there are certain niches and products that thrive when the economy as a whole is healthy (and suffer when the economy is in the dumps). This isn’t something that you need to consider in great detail, but at the very least you should have an idea in your mind about how your site or portfolio will perform under different economic conditions. A site about lightbulbs will likely be quite stable even in bad economic conditions. A site about luxury watches, maybe not so much.
Risk of Fraud
I’ve gone on about Due Diligence enough times on this site already, so this one is pretty self explanatory. Never forget the PPPLOAYM (Proper Planning Prevents Loss Of All Your Money). Refer to pretty much any of the other articles on the site to see my harping on about the importance of good Due Diligence – for example, here or here.
Final Thoughts on Risk
How you think about risk, and whether you take it seriously or not, will determine your success as an investor. It’s one thing to deal with a Google update that wipes out your rankings when you’ve already considered the possibility. It’s an entirely different thing if you’re taken by surprise. “It’s the punch that you don’t see that knocks you down” – this saying is well known in boxing circles, and it applies here.
When buying a website, consider the potential sources of risks and think about how you would deal with them. If you’ve already bought a website, start working on mitigating the risks that your site is exposed to. Learn how to weigh risk versus return – both in terms of the sites that you buy, and the way you manage them. As you get more experience, the assessment of risk will become second nature to you when considering any investment.
