Real Options Thinking for Early-Stage & High-Volatility Investing
Treat early-stage and high-volatility bets as options, not bonds — volatility and management's ability to exercise choices become assets, not risks.
- Difficulty
- Advanced
- Time to result
- ~months to results
- Steps
- 5
- Confidence
- 85%
Rather than valuing a young or highly uncertain company like a predictable cash-flowing business, Mauboussin recommends viewing it as a real option: the right, but not the obligation, to pursue future value. This reframes volatility from something to be minimized into something that makes the option more valuable, and highlights the outsized importance of management's skill at identifying and exercising options (his prime example is Jeff Bezos) and continued access to capital to fund exercising those options when the time comes.
Origin
Grounded in option-pricing theory dating to Black-Scholes in the 1970s, extended by academics in the late 1970s/early 1980s to apply financial option mathematics to real businesses ('real options').
Core principles
- 01Volatility increases the value of an option, reversing the usual 'lower discount rate is better' intuition for stable cash flows.
- 02Management's ability to recognize and exercise options intelligently is a major value driver.
- 03Access to capital is necessary to actually exercise an option when the opportunity arrives.
- 04Early-stage bets should be sized and evaluated like a portfolio of options, not individual bonds.
How to run it
- 1
Reframe the asset as an option, not a bond
Recognize that an early-stage or highly uncertain investment behaves like the right, but not the obligation, to capture future upside rather than a predictable stream of cash flows.
- 2
Assess volatility as a positive
Check whether the market or business context has high volatility — more volatility increases the value of the embedded option rather than detracting from it.
Watch out This is counter to standard discount-rate intuition for stable cash-flow businesses.
- 3
Evaluate management's option-exercising skill
Assess whether leadership has demonstrated the ability to identify and intelligently exercise strategic options as they emerge.
Pro tip Jeff Bezos is cited as a best-in-class example of exercising options.
- 4
Check access to capital
Confirm the company can raise the capital needed to actually exercise the option when the moment comes, since many good ideas fail purely from lack of funding access.
Watch out Historically good ideas (e.g., early online grocery/pet supply concepts) failed not because the idea was bad but because capital access disappeared in a downturn.
- 5
Size positions as a portfolio of options
Because payoff distributions for early-stage bets are extremely skewed (most return little, a few return enormously), build a portfolio rather than concentrating on a single bet's expected value.
In the wild
Webvan and Pets.com pursued similar online grocery/pet-supply concepts in the early 2000s but collapsed when capital access vanished after the dot-com bust. Years later, Instacart and Chewy pursued similar ideas and thrived, aided by more available capital.
→ Shows that the same option-like business concept can fail or succeed based largely on capital access rather than idea quality.
Common mistakes
Penalizing volatility like a bond investor
Applying standard discount-rate logic to a young company treats volatility as pure risk, when for an option it's a source of value.
Underestimating the capital-access constraint
Great option-like ideas (webvan, pets.com) failed in the early 2000s largely because capital access dried up, not because the concepts were flawed — later analogues (Instacart, Chewy) succeeded partly due to available capital.
Evaluating a single early-stage bet in isolation
Because payoff distributions are extremely skewed, judging one investment's price without portfolio context misses the point of option-like investing.
Is it for you?
Best for
Venture capitalists and early-stage investors evaluating pre-revenue or highly uncertain companies.
Not ideal for
Mature, cash-generating businesses better analyzed via discounted cash flow.
From the transcript
“where real options tend to be valuable is when you have sort of three or four characteristics in place first is it's good to have…”
“management's ability to understand options and exercise them intelligently is extremely valuable”
“the other thing is interesting is it is a feature is access to capital”
From the episode
Michael Mauboussin Master Class — Moats, Skill, Luck, Decision Making and a Whole Lot More
Michael Mauboussin