Risk and reward
Fortune favors the bold, a famous adage that implies that those who undertake significant risks will likely receive greater rewards. Why would that be the case, though? Because the chances of failure are higher, and only a lunatic would place a bet against the status quo for a prevalent return.
Examples of risk and reward
The banking system in the United States has essentially zero risk for individuals who deposit sums of $250,000 or less. Why? Because of the Federal Depository Insurance Company.
Known more commonly as the FDIC, this government-backed corporation acts as a failsafe to protect consumers from banks going belly up, and it has worked. Since the founding of the FDIC in 1933,” no depositor has ever lost a penny of insured deposits.”
Impressive.
Therefore, when banking at a reputable institution, you can rest assured knowing your cash is redeemable. However, you will earn a nominal interest rate for this privilege since your funds will always be available. And notably, with time, the result is a loss in purchasing power due to inflation. But your money is still there.
Not a bad trade-off for an emergency fund but a terrible idea if those are your retirement funds.
On the opposite end of the risk scale, we have casinos.
The casinos’ flashing lights, alcohol, and endless risk-taking opportunities are far from the unalluring lobbies that banks provide. At such establishments, you can bet on 00 at the roulette table.
For every dollar you gamble at a casino’s roulette table, the expected return is -$0.053. Hence, the odds imply that you will lose money (that is how casinos stay in business, after all.) Notwithstanding the chances, the payout for winning such a bet is 37/1, meaning that you earn a 3,700% return if you win immediately and walk away.
Not too shabby, but highly unlikely. Nevertheless, this blog is a finance blog, so let’s turn to the realm of stocks to see what risk they hold.
Stocks can be risky
When investing in stocks, you have a 96% chance of picking a loser if you go the route of individual stock picking. (Phrased differently, for every winner you choose, 24 will lose.)
Would you say those are great odds? I wouldn’t.
Furthermore, most actively managed mutual funds underperform the broader market, meaning that experts aren’t much better than laypersons at sorting through the market noise.
Lackluster, I know.
Fittingly, many investors have flocked towards index funds, which return whatever the market returns.
Index funds and risk
What has an indexed stock portfolio historically yielded? 10% a year on average.
While you might be thinking, “That is great! Why doesn’t everyone put their emergency fund in an index fund then?” The answer would be that the actual range of returns you could receive varies from -68% and +163% during any given year. Yikes, to say the least!
Such volatility is why stocks can be risky, even when buying the entire market. Thus, while a 10% average annual return sounds nice, predictability is anything but guaranteed, except for when it is.
Wait a minute, what do you mean, Olaf?
I’m glad you asked because, interestingly, something happens to risk if you have patience when index investing (and chasing your goals).
Another variable: time
The many examples above show that risk and reward are inextricably married, except for when we dilate time.
When zooming out to 20-year spans, the odds of losing money through a total stock market index fund is historically zero and instead generates positive returns. Furthermore, when leaving cash in a bank account for the same period, its value erodes due to rising costs.
Consequently, time can provide safety to otherwise risky endeavors and make less risky options dangerous (except for when gambling at the casino, individual stock picking, or betting on the next crypto trend).
As a result, we cannot simply strive for safety by doing nothing with our money or lives, as inaction is an action within itself.
For example, when first learning to ride a bicycle, you will likely fall. Heck, you may even get hurt. But, with determination and a long enough period, you are bound to learn how to ride the contraption. Plus, it will help you stay in shape and explore more of the world.
That is a pretty good trade-off for short-term discomfort. And the same is true when investing in index funds.
Yes, you can lose money in the short term, but you will likely become wealthy with time.
Risk is something you must consider
Risk is something every individual, not just investors, must consider. Risk shapes our outcomes throughout life, and therefore, we must plan accordingly.
When considering how much return you want to earn on your money, you must ask yourself how much risk is tolerable. Then you must weigh the benefits and the drawbacks of each answer.
Suppose you are unsure how much risk you can tolerate when investing. In that case, I suggest doing research and reading my previous post, You’re Investing Wrong: How to Use Portfolio Construction, where I use charts (courtesy of Fidelity Investments) to show corresponding yields compared to portfolio volatility (i.e., risk). Then, you can invest accordingly.
Elsewhere in life, you must repeat assessing various scenarios and outcomes. The result will be a richer life.
What are your thoughts on risk and reward? Where do you take risks, and where are you cautious? Furthermore, what have the outcomes been?
I look forward to hearing your experiences in the comments below, and as always, have a great day.
Mile High Finance Guy
finance demystified, one mountain at a time
Yeah I think for some things the analysis of risk is quite difficult. For example, I used to think something like 1/37 or like 4% chance of winning is OK, as long as the estimated payout is much higher (i.e. positive expected value).
But the thing is, for a lot of these sort of long-tail wins, it’s very difficult to estimate:
1) How often you’ll actually win — a lot of times, if it’s a new business or something like that, the probability of winning can actually just be 0%, but you don’t know that ahead of time because there’s no historical data to compare against.
2) What the rewards will be if you win. Same thing as starting a business, any “games” where the rewards are not clearly defined will have unpredictable rewards. You can estimate some unit economics in a business for example, but non-obvious things like macro-economics can completely alter your assumptions, every couple months.
You can win *some* games in the casino, like blackjack, if you count cards, with a +1% edge. But the variance of it can be enormous and you basically still need a large enough bankroll to absorb the variance. And even then, no bankroll is large enough to guarantee that an enormously unlucky streak won’t wipe you out, even if you’ve a 1% edge.
Exactly! The issue with games of chance is that you have no idea how many cycles it will take for chance to deal you a winning hand, and even then you may go bankrupt before hand.
With starting a business, most metrics are irrelevant. Yes, most businesses fail, but the way you deal with challenges, plus the unique circumstances of the market at the time you enter, will undoubtedly render prior assumptions null. Nevertheless, I think it is amazing that our country fosters so many start ups, which have fundamentally changed the way we live. But, that doesn’t dismiss the odds being slim.
Thanks for commenting, Angie!