Tuesday, August 4, 2015

Does Risk Equal Return?


Tom and Jerry

"Risk equals return" - you've heard the old mantra. It's an oversimplification. Invest in the riskiest deal and you'd be rich. That's not how it works - as anyone who has played the lottery can tell you.

The principle is, in fact, risk equals potential return. There's a difference. The gain is only a possibility and may not be realized. The more risk, the greater potential reward and greater potential loss. For example, the state lottery. Purchase a ticket for a dollar, and there's a huge potential return. If it hits, the winnings could be millions. The likely real world outcome is the dollar is lost.

The reverse is also true, the less risk, the less the potential reward. For example: putting money under a mattress (or in a safety deposit box) produces little chance of loss and no possibility of gain. 

Risk can be deceptive. We don't hear about the millions and millions of people who lose money in the lottery. We do see a front page headline about the one person in millions who hits the jackpot.

Your Risk Profile 

A decision you'll have to make as an investor is level of risk. This can be difficult. Questionnaires are one tool to determine risk tolerance, but they're not a perfect solution. In my experience, a ten question multiple choice test won't work. It's not that easy. 

Figuring out how much risk to take is hard because our appetite for risk changes over time. Investors are said to be ruled by two emotions: fear and greed. These are complementary. So as market conditions change, we change.

Ideally, you'll walk the line where the risk won't be too high when things are bad nor too low when things are good. It is a fine needle to thread, and it's an ongoing process because the line also moves based on changes in your life. 

The First and Best Warning Sign

Perhaps the best thing about understanding this rule is it leads to the best warning sign: if you see the principle of risk equals potential return violated, something's up.

This is the “too good to be true” red flag. If something promises big returns and little risk, look closer. When you do, I’m confident you'll find something in the fine print.

Make Decisions like Ben Franklin

So before every investment decision, ask the question: What are the advantages and disadvantages of the investment being considered? Often we consider only advantages. There are always disadvantages.

I recommend the Ben Franklin method of decision making. Get a paper and draw a line down the middle. Label one side "pros" and the other "cons." Make sure to write down every pro and con you can find. This may seem simple, but after reviewing the list, you'll likely make a better decision. This tool worked for Ben and it can work for you.

Continue to Part 2: The Arithmetic of Loss