The Relationship Between Risk and Return

At different points in your life you have a different appetite for risk. Personally, as a late twenty-something I feel like I am a little less risky than my early 20’s (down about $23K in stock market trading) but I still have a hunger to grow aggressively because I am simply not comfortable living the middle class lifestyle. I want big things in my life, not just to have big things, but to do big things.

It’s easier to do big things with money, but how can you get it. With some discipline and a comfort with risk it’s not impossible to build a fortune earlier in your life. I know a successful entrepreneur by the name of Dan Demsky who told me that one of his best motivators is necessity. Dan faced a looming tax bill in his early years as an entrepreneur and frankly told his team “we need to sell X dollars to survive” and they did. I believe that to be successful, you need to create a sense of necessity through goals, and you need to take calculated risks.

This perspective helps me lead into a discussion of risk and expected return. There is a simple principle in finance which states that there is a relationship between risk and return which is; the more return you expect to get, the higher the amount of risk you need to bear. Let’s dive a little deeper into a technical explanation.

The Risk Free Rate

There is a return in the market which you can expect to earn without taking any risk. This is called the risk free rate. An investment that is risk free is one that is considered to have no risk of default or loss and a prime example of this kind of investment is a Government bond (in Canada). Speaking truthfully, the government can default on a bond but it is highly improbable, so in the finance industry we often use this as a risk free rate. If you take no risk you should be able to earn this return on your money which right now is about 1% per year in Canada.

Your Reward for Bearing Risk

After you’ve decided that you’d like to earn a little more than the inflation rate, you may ask yourself “how am I rewarded for bearing risk?” There is also a standard unit of risk called ‘beta’ that earns you a “market risk premium” which is a return. In simple terms when beta is 1 you are taking the average amount of risk for the entire stock market.

 

Your expected return can be expressed as:

The risk free rate + the level of risk of beta (1 is average) * the market risk premium  = Expected return

 ⇓                                                     ⇓                                                                  ⇓

Return without risk    +     How risky your investment is      *       The reward you get for average risk

 

What does this mean to me?

This relationship can show you that you are in fact rewarded for bearing risk. When you plan for your future you need to consider if you can tolerate the possibility of loss for the mathematically greater likelihood of making more money in the long run. If I gave you the option of betting $1000 on a game in which you had a 51% chance of receiving $2000 back (+$1000) and a 49% chance of getting $0 back (-$1000). I would allow you to repeat the bet as many times as you could pay for it. Would you make the bet? Why or why not? Would your answer change if the bet was $100? Stay tuned for my next post to explain which decision I would make and why.

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