RiskMetrics - Is the Reward Worth the Risk?

Is the Reward Worth the Risk?

Risks are only worth taking if the upside justifies the potential downside.

More risk, more return

Hence, it makes sense that investors should expect to earn more money from investing in stocks (with very uncertain returns) than bonds, which guarantee repayment of principal and interest. Indeed, history has shown that in the long run equity investors have received greater compensation for taking risk than bond investors. For example, from 1950 to 1999, the average annual return of US equities has been 9.48%, compared to 6.22% for bonds. The ability to measure risk allows investors weigh opportunity against downside.

Good vs. bad risk

Is all risk created equally, or can we distinguish between good and bad risk? Bad risks are those where the downside outweighs the upside potential, or where the expected return is negative. For example, while crossing the street with closed eyes may provide some thrills, the high chance of becoming road kill makes this a bad risk.

A common example of bad risk is playing the games your basic casino offers where the odds are stacked against you. The money you put up in a game of roulette is a gamble, not an investment. Although you can make an easy win now, the long-term prospects of a gambler are miserable (the flip side is that investing in the business of casinos can be very profitable, as the odds are in favor of the house). On the other hand, investing in a start-up company is also extremely risky, and indeed, the majority of such private equity investments end up going sour. However, when viewed from a portfolio perspective, the potential for just a few such investments paying off can more than compensate for the losers.

Any disciplined investment decision involves first measuring the odds of success or failure.

"If you want to make money in Las Vegas gambling, then own the casino."

- Steve Wynn, Chairman of the Board, Mirage Resorts, Intl.

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