Risk and Return

The relationship between risk and return is one of the most fundamental concepts in managing money, and let us understand it with a simple example.?

Imagine there are three people in a room, and I ask each of them to lend me Rs. 100 and make them an offer.?

Person 1: He needs to jump from his standing position. If he lands without hurting himself, I will return Rs. 105. But if he injures himself, I will keep the Rs. 100.?

Person 2: I ask her to climb a ladder and jump down. If she lands without injury, I will return Rs. 105. But if she hurts herself, I will keep the Rs. 100.

Person 3: I ask him to go to the second-floor balcony and jump down. Same deal–Rs. 105 if he lands okay. Zero if he doesn't.?

Now, what do you think happens??

Person 1 immediately grabs the offer. He jumps on the spot and collects Rs. 105.??

Person 2 starts negotiating–she will only climb up the ladder if I better the offer. Her friend gets five bucks to jump up and down; she deserves more since she is more likely to hurt her leg. She agrees to a payout of Rs. 115 if she lands safely. She jumps, lands without incident, and collects Rs. 115.?

Person 3 looks at me as if I am crazy. Why would he risk his bones for a measly Rs. 5, or even Rs. 15? He is a risk-taker but wants the rewards to be meaningful. He will jump from the second-floor balcony, but only if I pay him Rs. 500 for a safe landing. We agree, he jumps but unfortunately lands awkwardly and sprains his ankle. I call him a doctor and pocket his Rs. 100.?

And this is the relationship between risk and return. The lower the risk you take, the lower your expected return.

Person 1 took the lowest risk and made the lowest return (5%, i.e. Rs. 5 on Rs. 100 investment). Person 2 took a bit more risk and made a 15% return (Rs. 15 on Rs. 100 investment). Person 3 took the most risk and stood to make a massive return on his Rs. 100 investment. Unfortunately, it didn't work out in this case, but he would have hit it big if it had.?

This is essentially what managing money is all about–deciding how much risk you are willing to take, thereby making returns that are in line with that risk. So, for example, you can keep your money under your pillow, which is a risk-free option, but it will also give you no return. You could put in a bank account or fixed deposit at negligible risk. But that gets you a minimal return. You could buy equities, which are higher risk, but the returns will be higher too. Or you could go all out to the second-floor balcony and buy cryptocurrencies or other speculative stuff and make a lot of money. But equally, risk losing it all.?

Everyone has a different appetite for risk, and there is no perfect answer to what one must do. But this is certain–the safety of bank accounts and deposits will not create meaningful wealth. And speculating or gambling everything on risky assets will not either. So, as with most things in life, the solution lies somewhere in the middle–finding the right financial products that will give you the returns you would like at an acceptable level of risk. And the beauty is that this journey is not very complicated, and we will traverse it together.?

Break a leg! Sorry, let me rephrase that …. Good luck!

Rishi Piparaiya?has held senior leadership positions in wealth management, strategy, sales and marketing with leading financial services organizations, including Citi, Aviva and Banco Santander. He left his corporate job at the helm of his career to pursue his passions. He is now a?bestselling author,?world traveller?and?angel investor.?His latest book, Three Pigs to Financial Freedom, demystifies financial planning and offers an incredibly easy system to manage your money for a comfortable, worry-free life.