Today, I want to talk about the concepts of risk and return. As demand and supply in economics, these are the most important concepts in finance, and they lay a foundation for understanding everything else that is there to know about this field.
Let’s talk about return first as it’s easier to understand the concept. If we are dealing with family and friends, chances are that if we do something for them or give them something, we don’t expect anything in return. This is definitely not the case in the business world, and when we deal with other market participants (individuals, organizations, even government), if we give them something, we do expect something in return. If we work for a company, we expect to get paid. If we invest our money, we don’t want to do it for free. We expect something back, and whatever we get back on top of our original investment is the return that we make. Let’s leave it at that for now.
Now, let’s proceed to a more difficult concept to grasp which is the concept of risk. There are many definitions of risk, and I will keep coming back to talk about risk at least a thousand times in the future. Financial books explain the risk as a standard deviation of returns. I’m pretty sure that, at this point, most of the readers will say, “Whoa, you’ve just lost us! What do those words even mean?” They mean variability of returns, and the fact that sometimes we don’t know if we will get +10% back, or -20%, or even if we will get back anything at all. The greater the variability of the actual returns compared to an expected return that we had in our mind, the greater the risk. It’s easier to explain on an opposite example. Let’s imagine a risk-free asset which, come hell or high water, will give us 5% back per year, and this will be its return. So, for every $100 we invest, in a year we will get $5 back, and this never changes, which seems like a pretty good deal. The return that doesn’t change over time makes it a risk-free asset.
Now, let’s imagine that we invest money into some kind of asset and expect 5% annual return back. However, in year one, it gives us back 10%, in year two 7%, in year three it’s down 25%, and in year four it’s up again by 7%. None of these numbers is 5%, and even if there were a 5% return in one year, in the rest of the years it’s completely different from what we expected. This difference (or variability) of returns translates into the concept of risk. The greater the variability, the greater the risk, and vice versa.
And here comes the key relationship to understand the rest of everything in finance: The greater the risk, the greater the return. And, consequently, the greater the return on an asset, the higher the probability that it’s riskier compared to another asset with a lower return.
In finance, there is the Capital Asset Pricing Model (CAPM), and it says that the expected return on an asset “i” equals to a risk-free rate plus the asset’s beta multiplied by the market premium (the formula above the cauldron). Without going into any technical details, this means that when we invest into a risky asset, we expect to get back a risk free return (usually a return on the shortest and most liquid instruments, T-bills, of US government) plus compensation for how much risk we take. Again, the higher the risk of the asset, the greater the compensation we expect.
The takeaway from all this is that when we see an asset that promises an almost too good to be true return, our first thought should not be, “Let’s invest all our money into it.” Our first thought should be, “Wow! This asset promises X% per year. It must be quite a risky thing, and we should think hard if I should even buy it.”
In the next post, I will continue talking about risk and return and will give you some examples to better understand what is the correct and smart way to compare the returns we should get back for the risk we take.