Finance Frameworks Part 6: No Risk, No Return (Part 6 of 9)
In finance, we can't get big returns without taking big risk. The same holds true in our personal lives. If we want outsized returns in life, we have to take risks--embrace fears--that others are not willing to take.
This is Part 6 of my nine-part series connecting financial frameworks with personal growth.
2. Assets = Liabilities + Equity: What You Own Comes with Strings Attached
3. Assets = Liabilities + Equity 2: What You Have vs. What You Can Use
4. Time Value of Money 1: The Power of Compound Interest
5. Time Value of Money 2: Why Humans Use Bad Discount Rates
6. Risk and Return 1: No Risk, No Return
7. Risk and Return 2: Why Humans Are Bad at Calculated Risks
8. Risk and Return 3: Diversification and Building Multiple Pillars of Resilience
9. Conclusion: The Emotional Balance Sheet
Over the past month, we’ve covered two of the three foundational concepts in finance—the balance sheet identity and time value of money—and how these concepts apply to our personal lives. This week, we’ll start the discussion of the third concept—risk and return—and how we can use lessons from the finance world to make better decisions in other areas of our lives.
Risk and Return
In finance, risk and return go together.
Return is something that investors want, while risk is something that investors want to avoid. You can’t get big returns, for the most part, without taking big risks. Why is this the case?
Imagine an investment that offers a given payment (say $100 per year) with a low price (say $200), and low risk (risk can be measured quantitatively in finance, but for simplicity, we’ll just describe it qualitatively here). That equates to a 50% ($100/$200) return each year.
In a world with open markets, the price of this investment won’t stay $200 for long. Investors will quickly bid up the price to the point where this investment is roughly similar in return to other investments with a similar risk profile. If other “low-risk” investments yield 10% annually, investors will bid up the price of this investment to roughly $1000 ($100/$1000 = 10% annual return).
If a high-risk investment also yields 10%, investors will try to sell the high-risk investment and buy the low-risk investment—why take extra risk if you get the same 10% for taking low risk? The price of the high-risk investment might fall to $500, resulting in an annual return of 20%, giving investors the choice of a low-risk investment that pays 10% or a high-risk investment that pays 20%. Something like this happens in actual, real-world markets, producing an a-la-carte menu of investments where you get to pick the combination of high- and low-risk items you want.
Risk and Fear
This concept maps directly to domains outside of finance, if we treat the word “risk” as a synonym for “fear.”
In finance, “risk” usually means the possibility that something unexpected will happen (including good outcomes!), or the possibility that something bad will happen. As a practical matter, investors are usually concerned about the bad things happening, or “downside risk.”
The emotion of fear manifests in the same circumstances—when a person enters an unknown situation, a range of things can happen, some good, some bad. Since fear evolved in connection with our survival instinct, the mind tends to focus on the bad things that can happen in the situation—the downside risk.
However, like in finance, doing things that feel “risky” include the possibility of good things happening, or “upside risk.” We will return to this idea in a moment.
No Risk, No Return
In order to get unusual returns, we have to take unusual actions. If we take the same actions as everyone else, we will get the same returns as everyone else.
What actions could be considered unusual? I’d say they fall into two categories—things that are hard because they require consistency and discipline, and things that are scary. We’ll focus on the latter here.
Most people are not willing to step into fear—they avoid risk. The mind is wired to think about what can go wrong—“I’ll look stupid, I won’t be good at it, I’ll fail”—and as a result, we don’t take the risk of stepping outside of our comfort zone.
But we don’t think about what can go right if we take a risk. This is the potential upside, that in finance, people do think about. If we never take any risk, we avoid the bad outcomes, and we also avoid the good outcomes. Outstanding outcomes in life lie in the actions other people aren’t willing to take.
This isn’t easy. Everything that is easy, people are already doing. The easy things are like the investments that may have looked like a steal in the past, but now the price has been bid up and the returns competed away.
The beauty of all this is that in life, the risk/reward tradeoff is much better than it is in finance. The reason it is better is that humans do a poor job of calculating risk. We will return to this topic next week.
Exercise
Journal on the following or discuss with a friend.
1) Noticing
Where in my life do I feel blocked from taking action out of fear? Implicitly, what are the risks I have not been willing to take?
What have I been procrastinating on? Where have I been rationalizing why I can’t do something now?
2) Risk Assessment
Regarding the action in question—what am I afraid will happen? What is the downside risk?
Hypothetically, if my fears turn out to be misplaced, what could go right? How could I benefit if I take the action?
3) Action
What risks am I willing to take in order to get the return I want?
When I stop to consider the upside potential, including positive outcomes that I didn’t expect or anticipate, how does that affect my ability to act?
Can I act from a place of thinking about the return first, and the upside risk before the downside risk?