The relationship between risk and reward is probably the most important - and most poorly understood - in your life. Learning to understand this relationship, and applying that understanding in every aspect of your life, will massively stack the odds in your favor, regardless of what other life choices you make.
Simply put, risk is the probability of an adverse outcome (ie. something bad happening) and reward is the payoff you receive (in whatever form) for having taken that risk. From how you choose to invest your money, to how you cross a busy street, risk and reward are constantly at work in every aspect of your life. They are immutable and inescapable. Take the example of crossing a busy street. The risk is getting hit by a car. The reward is how quickly you can get to the other side. In this scenario, the highest reward is available by running across the street (the quickest way to cross). This carries a level of risk which most people would consider unacceptable though (a very high probability of being hit by a car). So what do we do? Most people will sacrifice the reward in order to minimize the risk; sacrificing some additional time to use a pedestrian crossing – and all but guarantee not getting hit by a car.
To begin to optimize your relationship with risk, it is necessary to first understand the risks you face in any given situation – and the rewards that you are seeking. In the majority of cases, the rewards you seek will not be financial. They might consist of time time saved, pleasures accentuated, pain/suffering reduced, distractions minimized, clutter eliminated, or important relationships deepened.
Take a moment now to think about household clutter. You’ve probably got more of it than you realize. The reward from disposing of some of it is the improved sanctity of the space in which you live. The only risk is that you might later have a need for one or more of the things you disposed of, or might miss some of them. This seems like a tiny risk when compared with the gains in space and cleanliness you might achieve though – and that’s to say nothing of the extra cash you’ll have if you sell your unwanted items. I’m sure your average minimalist understands this well.
We tend to regard risk and reward as roughly equal quantities in a given scenario. They are not. Generally, risk and reward are strongly asymmetrical. There are some situations in which taking a small risk provides a rich reward (I call these ‘good’ risks). There are other situations in which vast amounts of risk are required in order to achieve a tiny reward (I call these ‘bad’ risks). Everything else is somewhere in the middle, but it is rare for risk and reward to have anything like a symmetrical relationship. A helpful tool here is the Efficient Frontier (see below), which was first put forward by Nobel Laureate Harry Markowitz in 1952. The red dashed line describes the maximum reward available for a given amount of risk taken in an investment portfolio. For the purposes of this model, it is impossible to have a portfolio outside the line – and any portfolio inside the line is considered sub-optimal (ie. it fails to maximize reward for the level of risk taken).
Risk in this case is expressed as volatility on the horizontal axis. I’ll deal with the Sharpe Ratio in a separate post…
Optimizing rewards is therefore a game (and it can be as much fun as any game) of understanding which risks you are taking and which rewards you are seeking. Once you start to view the world through this lens, I hope two things will leap out at you right away:
1. Zero reward is available without risk, so don’t try to avoid. Love it and embrace it. Jump on those ‘good’ risks wherever you find them. Avoid ‘bad’ risks like the plague.
2. It is possible to mitigate risk and maximize reward in most scenarios, thus moving your life out of the suboptimal pile, right onto Markowitz’s Efficient Frontier or even beyond.
In future discussions of this topic, I’ll provide more situational examples of risk and reward at work, but hopefully you’ve got enough of an idea for now. Of course, if you’re facing a particular challenge and you’d like some help with it, feel free to book a session with me and we’ll go through it in detail.
There is so much you can do to improve your relationship with risk and reward – and I hope this article has gotten you off to a good start with improving yours. As with most relationships, this relationship is a deeply personal one - and will look very different for everyone. That’s totally natural and okay. At Afinitiv LLC, understanding risk is central to what we do. If you're ready to have your money managed by people who have the technical knowledge and genuinely care, please Join Us today.
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