Beginner Lessons Lessons 1-5

Lesson 3: Risk and Return

It has been in my learning experience that there is no one definition of the word risk. There are many variations on the concept and many ways to view it.

Risk in my opinion could best be described as “uncertainty of results due to the inherent unpredictable nature of the future”. To put risk differently if you had psychic powers and could accurately see what the future held you would have no risk in your life as there would be no uncertainty to outcomes.

 Key Points

  • Risk is the chance that your expectations concerning a return are not what actually occurs
  • There is a fundamental relationship between risk and return of an investment

Now the world of finance has a very specific working definition of risk. In finance risk is defined as the possibility that an investment’s actual return will differ than the return you expected. Let’s go back to the art of Mr. Veray Artsay. Say you thought your $1,000 investment would turn into $5,000 five years later.  Risk in this case is the possibility that the art will be worth anything other than $5,000 five years later.  There are many, many, many types of risk in the finance world and we will describe some of the more specific types later.

So why would a person want to take on risk? Wouldn’t it be better to invest in risk free things and grow your money that way? This leads us to another fundamental idea in finance: risk vs. return.

The Risk-Return Tradeoff

So before we get into this idea let’s quickly review these two terms. Risk is the chance that your return will not be what you expected with higher risk equal to higher chances your return will be far from your expectations. Return is how much growth or shrinkage (come to find out it’s bad in most situations) your initial investment goes through over a period of time.  Now are you ready for your mind to be blown? Hope so because this is one of the most fundamental ideas in finance.

There is a direct relationship between the amount of risk an investor takes on and return.  Put differently, only by offering the potential chance for a higher return will an investor be willing to take on more risk.

Risk-Return Example

Say I offer you another two deals (finance people love their deals) Option A. I give you $100 every day for the rest of your life. Option B. I give you $100 for the rest of your life but every day I will spin a wheel with eight colors and if it lands on the red color, you stop receiving the $100.

Now any rational person would choose option A because option B exposes you to greater risk (the $100 may stop) but offers no greater return (you are still getting $100 in both situations).   So that was an easy one, but let’s change the circumstances a bit.

Wheel of color outcomes
This wheel. (Art is hard y’all)

Alright new two deals to consider. Option A. I give you $100 every day for the rest of your life. Option B. I will give you $100 for every day for the rest of your life but every day I will spin a wheel with eight colors. If the wheel lands on red you will not receive your $100 for a week, but if the wheel lands on yellow you will receive $200 per week.

Which situation do you choose? A bit harder to decide this time isn’t it?  This is mainly due to the fact that while Option A presents a risk free choice, Option B presents the opportunity for a higher return but comes with higher risk as well.  The “best option” depends on your preference for risk. If you are risk-seeking, you may take Option B and bear the weeks when the wheel lands on red. If you are risk-averse, you would probably take Option A and sit on your ever growing pile of $100 bills.

So is there any way to address risk in the market? There is one way to commonly address the presence of risk in investments and that is the subject of our next lesson.

Definitions

  1. Risk: the chance that expectations of a return will not match actual results
  2. Risk-averse:  a disposition to not take on additional risk
  3. Risk-seeking: a disposition to take on additional risk in exchange for the possibility of achieving higher returns

Further Reading

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