Risk and Reward

When most people think of risky things they think of the bad things that can happen. Thinking only in terms of “bad things” is an incorrect application of risk. The technical definition of risk is: the amount of uncertainty in the outcome of an event.

This definition of risk relates to the efficient use of capital through investing, because the amount of uncertainty in the return you are expecting from your investment is directly correlated to the amount of return you will get. I know that sounds confusing, but stick with me this gets good. Think of it this way, if a bank offers you 1% return on your investment you should expect to get exactly 1% return on your investment. If you invest in the stock market you should expect to get around 7% return on your investment.  Unlike the bank, the stock market return is unpredictable.  Your actual return on investment can range from +45% and -35%, but on average you can expect your long term investment return will be 7%.

To demonstrate this concept I’ve drawn the picture below. The far right of the picture shows what the stock market expected returns looks like. People are averaging about 7% a year, but they experience years where the return of +45% and other years where the return of -35%. In the middle I’ve shown what the bond markets expected return looks like. On the left of the image is what a typical government bond would look like. If we took it to the extreme left a bank savings account would have no distribution. It would just be a flat line because you are going to get exactly the return the bank tells you. No more no less.

Risk Return

 

So how can we use this concept to manage our capital more efficiently?

By planning when you will need to use your money you can invest at the appropriate risk level. For example if you don’t need your money for another 35 years you should be willing to take on a large amount of risk, because the investment carries the highest long term average return. Sure you will have bad years where you lose more money than you’d like to admit, but you will also have amazing years to go with it.

If you need your money in a few months to buy a car don’t invest it in the stock market. Yes, you could end up driving a Porsche, but you might also end up having to buy my neighbor’s car.

The Porsche

 

Beater car
My Neighbors Car

 

 

 

 

In a future post I’ll cover negotiation to help you get a really good deal on my neighbor’s car, unless he reads this also. Please subscribe on the right hand side of this post so you get that update.

 

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