The Relationship of Risk and Return Part 2

Last week I posed a question to you at the end of my post asking:

Would you exercise 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, $1?

One respondent’s first answer to this question was that he would not take the bet. He told me that even though there was a 51% chance of winning $1,000, there was also a significant chance, 49%, of losing your $1,000. When I explained to him that you could repeat the bet as many times as you like, he was still weary of losing $1,000 every time, and going broke. Truth be told this is a possibility but the more times you can repeat the bet, the more likely you are to reach the expected average of 51% success. This example brings to light a very important fact – risk can be mathematically calculated, and if you can find something that returns more money than the risk level would usually return, you will be a winner more often than not, and what else can we hope for?

When there is a 49% chance of losing your money, the odds of losing 10 times in a row are less than 0.09% which is just less than 1 in 1000. The expected value of your bet given these chances is expressed as $2,000*51% + $0*49% = $1,020. To make this bet costs you $1,000, and your expected value according to some solid math is $1,020. Every time you make this bet, you are theoretically buying something worth $1,020, for only $1,000.

In essence, after you made this bet 100 times, you should have made $2000. Now, not all of us have a cash reserve large enough to support making this bet with enough repetition to reap serious rewards, which is why I suggested using $100 or $10 instead. If you have $20,000 and can make a $100 bet 200 times before going broke, the odds are heavily in your favour to earn on average $2 every time you make a bet.

Buying something for less than its market value

Robert Kiyosaki, author of Rich Dad Poor Dad showed us that your profit is actually gained when you buy something that is undervalued.

Every time you have the opportunity to buy something that is worth $1,020, for a cost of $1,000, after all things are considered you will be ahead $20.

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