Ruminations on Risk and Return

Many people are familiar with the widely accepted notion that risk and return go together, but are unaware that it is an incomplete and misleading formulation. Let me restate it thus: "Return equals risk, which doesn't equal return." Obviously an explanation is in order.

Here is all you need to know about risks & return

Return equals risk.

Almost certainly if someone earns very high returns they ran very high risks to do so - though it may not be obvious in hindsight. Indeed, many people who become phenomenally wealthy (not just well off) are people who took incredible risks that subsequently paid off. Countless others took similar risks that didn't pay off. The second group is more representative of what will likely happen, but the first group is featured more in the media. In other words, we hear much more about lottery winners and dot com millionaires than we do people who consistently saved and invested over long periods of time or the people who lost everything attempting to win big. The savers are MUCH more likely to become financially independent than those who took outsized risks. The fact remains though - to earn higher returns, more risk must be accepted.

Risk doesn't equal return.

We need to differentiate between "good" risks and "bad" risks. In the financial field these are known as systematic and unsystematic risks. Systematic risks are "good" - they have higher expected returns and are prudent. Unsystematic risks are bad - they have lower expected returns than would be indicated by the level of risk, and they are imprudent. An example of a systematic risk would be investing in a diversified portfolio of stocks rather than keeping all of the money in CDs. An unsystematic risk would be purchasing one stock instead of the portfolio. There is an increased expected return from purchasing stocks over keeping money in CDs. In other words on average the investor will do better with the stocks. Conversely, purchasing one stock instead of the portfolio has much higher risk, but the expected return is the same. Similarly, most gambling is not very prudent because while the risk of loss is high, the expected level of return is actually negative! The average return on lottery tickets is about 50 cents per dollar spent and in casinos about 85 cents on the dollar. In other words every time someone spends a dollar playing the lottery they lose, on average, 50 cents. To recap, you can't get higher returns without higher risk, but you can absolutely get high risk without higher returns!.

Gambling vs. Investing vs. Insurance.

Many people mistakenly think there is no difference between gambling and investing or gambling and insurance. It is true there are some similarities - they are all related to chance occurrences, but there are significant differences as well. There are three aspects in which these "products" will impact a financial plan. In general, people prefer to have higher returns, lower risks, and a higher probability of meeting their lifetime financial goals. Using these products as they are designed to be used, we get these results:

As you can see, there are no products that give us positive effects in all areas. In other words, as we have been stressing, you can't get higher returns and lower risks simultaneously. Note though, insurance can reduce certain risks and thus help achieve financial success; investments can increase expected returns and also help achieve financial success. Gambling has no such redeeming characteristics.

How much? There is actually a process to determine what level of risk and return is appropriate for a particular situation. Financial plans should be designed to yield the highest level of happiness possible across all possible future scenarios. In general, that means taking prudent risks that raise the probability of reaching financial goals is generally appropriate while taking actions that decrease the probability of financial success are unwise.