All Risks are not Equal - Know the Return on the Risks You Take

Whether you invest in an opportunity or not is a simple matter of finding out if the odds are in favor of the most desirable outcome, i.e., whether you make the most returns on that investment.

I wish things were as simple as this. What this picture misses is that most of the times, the higher the risk in a investment, the higher the upside opportunity. So, now you have two variable to keep track of - one is the probability of the different outcomes and the second is how discounted the present opportunity is given the chance of an unfavorable outcome.

Consider the following example. You are offered two cars to choose from: First one is a 200K miles Toyota Camry, drives like a charm and is in excellent condition. The price tag is $5000. The second one is a Mercedes Benz Class E, been on the road for less than a month, just got in an accident and is offered for the same $5000. The Merc certainly needs some body work, but the engine starts and looks to be more or less ok.

With this limited information, which car would you choose for your $5000?

At face value, the Toyota seems like a safer, less risky choice. For the $5000, you can probably drive another 50K miles without much issues and make the dollar's worth. Merc at $5000 is a risky choice. You have to spend more money before you can drive it for the rest of the decade. How much more money is uncertain, but lets say it certainly does not look more than $20K. So, at $25K of your total spend, if you get to keep a nice $60K car, I would say it is a pretty good deal.

In the absence of additional information, the Merc deal looks very risky and not worth the risk. But if you are in the car business where you buy and sell cars all day long, you would have preferred the Merc deal to begin with. This is because even if this particular deal turned out to be a lemon, you will find many other such deals where it would have made your investment worthwhile. As a statistic, if you bought 8 such Merc deals for $5000 and only one of them turned out to be a worthy car to keep and you spent the extra $20K for the repair, you would have broken even on the Merc's value. So, what are the odds that you will make a bad judgement 8 times in a row? I would say pretty low.

The price at which a risky deal is discounted is very important to appreciate before turning the deal down. Sometimes the price alone can make the deal a good one. Another way to say this is that the return on that risk is justified to take on the additional risk.

From a risk to return trade off the Toyota Vs Merc deals are more or less the same. With the Toyota, you take less risk, you get a smaller reward. With the Merc, you take a larger risk and you may get a commensurate and larger reward.

In everyday financial instruments from cash, to certificates of deposits to bonds and stocks, you can see this return on risk concept play out. The riskier instruments offer higher returns on average.

The flip side is also true. When you see high returns in an instrument, look for what risk is being priced in to justify that return. Think about the favorite stocks you own - you see they have made good returns for you in the past, have you thought about the risks and understand them?

As you evaluate the risks in your portfolio, we are here to help answer any questions you may have.