The Risk-Return Tradeoff
The risk-return tradeoff: The higher the risk of an investment, the higher the expected rate of return must be.
The above statement makes sense, doesn't it? After all, none of us really likes risk and we certainly wouldn't accept extra risk unless we received something valuable in return.
For example, let's assume that you have a chance to put $1,000 into a savings account at your local bank at a 4% interest rate. But before you do that, I tell you, "Consider this: Lend me the $1,000 instead and I will pay you the same 4% rate as the bank." Which are the two alternatives would you choose?
If you're smart, I think that you would choose to put the money in the bank. After all, the bank account is federally insured and you will receive your $1,000 back even if the bank goes bankrupt. The bank also has several layers of people who have oversight responsibility: the bank's top management, the Board of Directors, and a federal regulator - all with the responsibility of making sure that you get your money back.
I, on the other hand, have no one reviewing my actions - I can do whatever I like with your money. If I go bankrupt, you will have a difficult time in getting your money returned. In other words, your risk of lending the money to me is higher than putting it in the bank and, since you don't get any extra return, you choose the bank! No surprise there.
However, what if I offered to pay you a 7% rate of interest? Or 10%? Or 15%? Then I might be able to persuade you to lend the money to me. In other words, even though the risk is higher, you now are able to earn a higher rate of return to compensate you for that extra risk.
Let's modify the choice slightly. Let's assume that I offer to pay you a 6% rate of interest but that I also offer you certain guarantees and additional information. For example, I promise to sign a legal document that places my car and home up as collateral for the loan. I also give you some additional information (with legal documents as proof) - more specifically, that I am a tenured college professor with high job security, have a decent salary, have an unblemished credit record, and that I have held the same job for over 20 years. In other words, I'm a pretty stable guy and am likely to pay you back. If I don't, you get to keep my car and home! To summarize, I'm not offering you any more money than the bank will pay, but I am offering to reduce your risk of lending the money to me to a minimum. Would you be willing to lend the money to me now? Perhaps so.
Notice that we have two situations here:
In the first example, I offered you a higher rate of return (interest) to compensate for the higher risk. I agree that the risk of lending the money to me is greater than the bank alternative, but I'm hoping that the higher return will persuade you to lend the money to me.
In the second example, I didn't offer to pay you much more than the bank, but I did reduce the risk to the point where it is essentially the same as the bank deposit.
In both cases, your goal is to maximize your return per unit of risk. I might be successful in persuading you to lend me the money either by (1) increasing your rate of return, or (2) decreasing the risk to which you are exposed. Both situations (or a combination of each) will tend to increase your return relative to the risk and will therefore make you more likely to accept the proposal.
But doesn't this principle apply to almost everything that we do? It is my contention that the risk-return tradeoff enters into every decision that you make, from the smallest to the largest.
Crossing the Street
For example, when you cross the street each day, what do you do? You look one direction, then the other to make sure no cars are coming. Why do you do this? Obviously, to reduce the risk of getting the image of a hood ornament imprinted into your forehead. You only cross the street if the return (getting to the other side) is greater than the risk.
What about the food that you buy? Before you buy a bunch of bananas, what do you do? You examine the bananas to make sure that they don't have an excessive number of black or brown spots and haven't been bruised. Why do you do this? Obviously, it is to make sure that the bananas will last a reasonable time after you purchase them. In other words, you're trying to assess the risk of buying the bananas. You will only buy them if the reward (the enjoyment of eating them) is greater than the risk (the bananas going "bad", so you don't get your money's worth).
Buying a Car
If you buy a used car, what do you do? You test drive the car, listening for any unusual sounds and evaluating how the car handles. You may even take it to a mechanic to have it examined to make sure there are no mechanical defects. Again, what's the purpose of this? You're assessing the risk of buying the car. After all, you don't want to end up buying a "lemon." You only buy the car if the return (the satisfaction and utility of driving the car) exceeds the risk (the cost of purchasing, maintaining, and driving the car).
Falling in Love
Finally, let's be hopelessly unromantic for the moment - consider the case of the person that you fall in love with. Let's assume that a man asks a woman out on a date. What determines whether the woman says, "Yes" or "No"? After the question has been asked, in the space of about two or three seconds, the woman will weigh a number of factors - all related to either risk or return:
What do I have in common with this guy?
If everything checks out, the woman may very well say, "Yes, I'd love to go out with you." If the risk factors seem too great or if the potential return seems too small (i.e., she doesn't think that she would enjoy the evening), she may very well say, "No, I'm sorry, I'm busy that night." ... "No, I'm busy that night too." ... "No, that one too - sorry." ... "Sorry, I'm going to Siberia that month."
Try to think of a decision where the risk-return tradeoff doesn't apply. If you can't come up with one, I think that you will agree with me that the risk-return tradeoff governs virtually every decision that we make in life, from the smallest decisions to the largest. It may very well be the most important of our 8 principles of finance. After all, it is the cornerstone of every free enterprise system in the world and the basis for virtually all of our personal decisions.