Saturday Mail — Future Premia, Risk Premia and few other terms every Software Engineer must know
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Hello Everyone,
First of all, a very happy Diwali to all of you and your family. Hope everyone is in good health and doing well.
Our topic of discussion today is around a few terms and their implication into the decision making process of Software Engineering, that we have conveniently borrowed from the Finance Industry.
Future Premia
In layman terms, Future Premium is an amount that will get deposited to you in future in return of a lump sum debit in the present time. Take this for an example, you deposit an amount of ₹ 1 lakh to a Bank’s Fixed Deposit scheme at 4% p.a. And this interest will be paid out every month. So the amount ₹ 334 that you’ll receive every month, approximately, is your future premium for giving up on the principal amount in the present.
Now put that into perspective of decision making in Technology/Software. Let’s say a stakeholder comes up to you and demands a feature in your existing product. As the product already exists, we can safely assume that there are some frameworks and processes put into place. But still do we go ahead try to build the feature, or wait for detailed explanation on Why, What and How before we do. Not only that, we align it to our existing standards and procedures so that it becomes easy to integrate and more importantly work on top in future.
This gets even more complex, if this product was not entirely in existence beforehand, but has to be built from scratch. You have to choose a platform, technology, language and frameworks and so many moving pieces before you can even start working. And why are these all needed right in the first moment of inception? All because, it would become more and more costly to change a decision based on progress already made. So here, we give more liberty and enormous velocity in order to have sanity and sensible velocity in the future. Anytime you face a choice, remember it’s less about the problem or solution or even the machines that run the solution, but more on people that are and will be working that solution.
Now one from a leadership perspective. One might hire a bunch of expensive Engineers to figure out a solution to a problem domain they have found. So in the present they hold a lot of liability in form of payrolls. Now if the solution works out and sticks to consumers, then they are going to make a hella profit, surpassing the cost at the very beginning.
Risk Premia
I think this justifies the purpose here vividly. Risk Premium is the amount you get awarded for taking up on a risk. Most oftenly, this Risk is associated with a new venture. You might help someone start a business by putting your hard earned money into their company as capital, and once it becomes a profitable venture, it might give back a portion of the profit as a token of appreciation to you, in the form of a dividend.
The same thing we do with our choice of tools and technology everyday, heck we do that with people as well. Everytime you hire someone, you are taking a risk based on their intrinsic potential to your or your team’s best capability. If you are having a tight screening process, chances are very low that whoever tops the hurdle would be a burden, but that possibility is never zero. Not just that, you may end up with a lot of false negatives as well, dropping well deserved and skilled competent people. But you still have to take the risk to bring about a change.
You can also for example, work on an experimental technology or build yourself one. That would bring upon a huge risk as there are a lot of unknowns in that territory but it would also give you enough liberty to come up with fresh ideas and have a huge amount of learning which can be encashed in multiple different ways. Think about people who first started building websites, or chat applications or blockchains.
Risk Reward Ratio
Also knowns as Cost Benefit Ratio
At the very core of any decision we make in the face of certain uncertainty, is our evaluation of Risk Reward Ratio. Everytime one has to evaluate, what is the reward I can expect at least, given the risk I will be taking up or the cost I will be paying for. And this sort of comes down to an aggregation of the two terms that we have learnt already, Future Premia and Risk Premia. Is the aggregated amount benefits on a given time period over the investment in the present. Or simply put, is the ration skewed toward the benefit or reward side of the equation.
You might have come across multiple articles talking about how Software Engineering companies are reporting huge losses everyday. How Amazon made huge cumulative losses over the year and only recently became a profitable organization. And you might have wondered why that is. People from some part of the political spectrum might have said, to avoid paying Taxes. Even though that is in fact, the true effect of this behaviour but never the only intention. As it is clear as daylight, no matter how much you want to avoid investing into public property and infrastructures, burning your own wealth down to the ground could never be a sustainable solution to the problem. And yet it became the norm with post DotCom Crash companies to report or make a loss every fiscal year.
Now truth be told, there are lots and lots of reasons behind them. And each reason is more sensible than others. But since we are not here to explore business strategies of these companies, we will only look at its implication and significance on the day to day operation and leadership goals. And that is where the Risk Reward Ratio pops up. Would like to book a $3000 profit and pay taxes on that with appropriate rate and take rest to your home; or re-invest that back into your company, maybe hire one more Engineer to make your product even more profitable, increase reach or spend on marketing or even as simple as buying every employee some electronics to help them with their work. Each of these scenarios increase productivity inside the organisation, which in turn makes the organisation even more profitable than it would have been, but at a cost of illiquidity.
Now I will stop here. And expect all of you to take a deep breath. It’s already been a long day and I just threw a little more jargon at the noise. But I truly hope you grasp the value of these concepts and apply them into your own way of decision making. Looking forward to knowing further from you about how you perceive these, if you would like to share some of such terms and concepts from your knowledge that helps in making decisions.
Happy Holidays everyone. Stay Home, Stay Safe and keep your family healthy.
— The Pro Dev Newletter, November 6th, 2021
Link to original publication: https://groups.google.com/g/theprodev-newsletter/c/lvbnSbtMi8Y
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