Understanding Risk and Return

Understanding Risk and Return

To get profit without risk, experience without danger, and reward without work, is as impossible as it is to live without being born. – A.P. Gouthev

Two key concepts provide the foundation for the field of finance.
1. A dollar today is worth more than a dollar tomorrow – this is the time value of money.
2. A safe dollar is worth more than a risk dollar.
The trade-off between risk and return is the principal theme in the investment decision.

RISK AVERSE: Most people are risk averse. This does not mean, however, they will not take a risk. It means they take a risk only when they expect to be rewarded for taking it. People have different degrees of risk aversion; some are more willing to take a chance than are others.

RISK NEUTRAL: Someone who is indifferent to risk is risk neutral.

RISK SEEKER: Someone who actively seeks out risky situations (a gambler) is a risk seeker.

• For small amounts of money, most people enjoy the thrill of a long-shot wager.
• For more significant sums, though, the tendency to risk aversion is nearly universal.

RETURN: People invest because they hope to get a return from their investment. Return is the good stuff that makes people feel better or improves their standard of living.

RISK: Risk is the bad stuff a risk averse person seeks to avoid. It is a fact of investment life and is unavoidable for anyone who seeks more than a trivial rate of return. Note that risk is a “four letter word.”