Risk & Reward
In all areas of our lives, we seek to eliminate needless risk and manage the unavoidable risk. Needless risk would include absurd behavior such as repeatedly running red lights. This practice carries an extreme—life or death—risk and negligible reward which is getting to your destination a few minutes sooner. I think we can universally agree that this is a risk we should eliminate.
Unavoidable risks that we should manage would include a fire at our home. While this rarely happens and only involves a minuscule segment of people within the entire population, the consequences of losing our home and all our worldly possessions is so high that we must manage this risk. The risk of fire is best managed through adequate insurance. While some people can self-insure the loss of their home and all its contents, these wealthy individuals predominantly still decide to carry fire insurance coverage, and they may reduce their cost by carrying a higher deductible.
Once we have eliminated all the risks we can and managed the risks we cannot eliminate, we turn our spotlight on how we invest our funds. Most people assume that the greatest risk in investing their money is the risk of losing their principal. These people might decide to bury their money in their backyard so they don’t lose it. In this case, they have overlooked the greater risk which is the ever-present, looming impact of inflation. While they may preserve their dollars which are buried in their backyard, throughout the ensuing months and years, their dollars will shrink and lose their purchasing power because of inflation.
It’s important to remember that none of us really want money. We want the things money will buy and do for us. Inflation erodes the positive impact that money can have on our lives.
Let’s examine two investors and determine which is being exposed to the greater risk. Investor A finds a relatively stable investment that delivers an annual return of seven percent. Most people would assume that this is a good outcome. Investor B decides to take a bit more risk and divides his money among five different higher-risk investments. In the first investment, he loses all of his principal and has nothing to show for these hard-earned dollars. His second investment makes zero return and only returns his principal to him. His third investment gets a five percent return which is eclipsed by Investor A’s seven percent return on his entire portfolio. Investor B’s fourth investment earns a healthy ten percent return, and his fifth investment returns a strong twelve percent.
While it may appear that Investor A has taken less risk and received a higher return, in actuality, 25 years later, Investor B will have 22% more money even after losing his principal in his first investment and getting no return on his second investment. You simply can’t assess risk without evaluating reward.
As you go through your day today, eliminate risk when you can, and manage it when you can’t.
Today’s the day!