Risk Severity vs. Materiality
Understanding the difference between how bad something is and how much it matters to your investment decision.
Two Different Questions
When evaluating risks, investors often conflate two distinct questions: "How bad is this risk?" and "How much does this risk matter for this specific investment?" These are related but different inquiries, and understanding the distinction is crucial for good decision-making.
Severity
"How bad could this get?"
Severity measures the potential impact if a risk materializes. A high-severity risk could cause significant financial loss, operational disruption, or project failure.
Materiality
"How much does this matter for my decision?"
Materiality considers probability, mitigations, and context. A risk might be severe but immaterial if it's extremely unlikely or already well-mitigated.
The Severity-Materiality Matrix
We assess both dimensions for every identified risk. This creates four quadrants that require different levels of attention:
| Low Materiality | High Materiality | |
|---|---|---|
| High Severity |
Monitor Serious if it happens, but unlikely or mitigated |
Critical Requires immediate attention and deep diligence |
| Low Severity |
Acceptable Normal business risk, no special action needed |
Address Not catastrophic but likely to affect outcomes |
Examples That Illustrate the Difference
High Severity, Low Materiality
A solar farm in a region prone to hurricanes. Hurricane damage could be catastrophic (high severity), but the project has comprehensive insurance, the panels are engineered for high winds, and the region hasn't had a major hurricane in 40 years. The risk is severe but not material.
Low Severity, High Materiality
A startup's only software developer has no backup and hasn't documented the codebase. If they leave, it's not catastrophic—others can eventually figure it out. But the probability of departure is high (single points of failure usually fail), and recovery would delay everything.
High Severity, High Materiality
A project requires a government permit that hasn't been granted, in a jurisdiction known for unpredictable permitting. If denied, the project fails completely (high severity). Given the jurisdiction's track record, denial is a real possibility (high materiality).
Low Severity, Low Materiality
A company's website has outdated branding. It looks unprofessional but doesn't affect operations, and their customers are B2B relationships that don't come through the website. The impact is minimal and the probability of it affecting outcomes is low.
How We Determine Materiality
Materiality assessment considers multiple factors beyond raw probability:
Probability of Occurrence
How likely is this risk to actually materialize? We consider historical data, industry norms, and project-specific circumstances.
Existing Mitigations
What safeguards are already in place? Insurance, contracts, redundancy, and operational procedures all affect whether a risk is material.
Time Horizon
When might this risk materialize? A risk that could occur in 10 years is less material than one that could occur in the next 6 months.
Detectability
Would you see this coming? Risks with early warning signs are less material than those that arrive suddenly without warning.
Reversibility
If the risk materializes, can the damage be undone? Reversible risks are less material than permanent ones.
Why Both Metrics Matter
Conversely, don't dismiss low-severity risks just because they won't be catastrophic. Death by a thousand cuts is real. Multiple "small" issues that are highly likely to occur can collectively undermine an investment.
Your Own Materiality Assessment
Our materiality ratings represent a general assessment. Your personal materiality may differ based on:
- Your risk tolerance and investment thesis
- Your portfolio diversification (concentrated exposure = higher materiality)
- Your time horizon and liquidity needs
- Your domain expertise (you may know more about specific risks)
How to Use This in Your Diligence
- Start with high-materiality risks. These are the issues most likely to affect your investment outcome. Dig deep, ask questions, verify claims.
- Don't skip high-severity items. Even if materiality is low, understand why. What mitigations exist? Are they robust? What would change the probability?
- Look for patterns. Multiple medium-materiality risks in the same area (e.g., several operational concerns) might collectively represent a high-materiality theme.
- Challenge our assessments. We may have information you don't, but you may have context we lack. If you disagree with a materiality rating, dig into why.
See It In Practice
View risk assessments on actual projects to see how severity and materiality ratings are applied.
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