Monday, May 30, 2011

Risk vs. Reward

Sorry, this is a particularly busy week for me so this entry will be short and sweet.

A common misconception about the financial markets is that risk is completely correlated to reward.  That is to say that if you want to get a higher return on an investment, you need to assume more risk.  I have not found this to be true in reality, and I want to take a few minutes to explain why.

First off, why does risk and reward seem to go together so well?  Well, let's look at two examples.

First is a company that you own that can either make $5 or -$5 for the year.  Let's say you bought the company for $100.  This means that you can expect somewhere between a -5% return and a 5% return.  Now, suppose that you bought the company for $20 and assumed $80 worth of debt.  For simplicity sake we will assume the debt has no interest (What a nice situation to be in!)  If we get a -$5 or a $5 return, it is now on our $20.  This means that we will either get a -25% return or a 25% return.  The reward has increased but so has the risk.

Leveraging yourself with capital increases risk in tandem with reward.  This is why most people associate them.  The effects of leveraging are present in nearly all firms, real estate, or other investments.

Secondly, the type of business people are in can often affect the volatility of their earnings.  For example, a food company will be a lot less volatile and risky than a tech company, all things considered.  Also, one can expect that the potential reward is much higher in the case of tech companies.

When we combine these two factors, it seems that risk and reward are often correlated.  This is, however, coincidental at best.

As value investors we look for companies that will provide high reward with low risk.  We do this by examining companies that have little downside but a pretty decent upside.  These companies often have quite a bit of extra cash and current assets on hand.  Imagine a condo that you plan to buy for $100,000 and intend to rent out.  When you walk into the condo, you find that someone has left a briefcase in the condo with $80,000.  Clearly your downside is limited only to $20,000 in this case.  There are many cases of this happening in businesses that are out of favor.

Never think that risk and reward are completely correlated because it will lead you to make very bad financial decisions.  One should never assume any more risk than one needs to.  Risk is to be avoided and circumvented.  If you start putting your finances in risk simply because you assume it will make you more reward, you can end up in serious trouble indeed.  And our object here is not to see violent swings in our net worth-- it is to grow richer and richer as the years progress.

Best regards, a more compelling article next time I promise!

1 comment:

  1. The risk reward is right when everyone is selling and nobody is buying.