Investment Risk Versus Reward: Navigating the Complex Relationship

December 14, 2021

Investing, Stocks

We all love a neat little saying—something that pops up in a vaibishe magazine or WhatsApp chat and feels like deep wisdom at first bite. But look closer, and most of these lines come apart at the seams like:

“No pain, no gain.” No. Sometimes, pain just means you pulled a muscle dancing in high-heels and a hefty medical co-pay.
“You get what you pay for.” Have you tasted those creamy, gorgeous, and expensive birthday cakes? What about those Shabbos shoes that come apart after two wears?
“If you want something done right, do it yourself.” Sure—right after I finish bookkeeping, fixing the leak, and some brain surgery.
“Failure is not an option.” Have you ever heard the other side of that? If you find yourself in a hole, stop digging!!

These slogans stick because they’re short and they feel intuitive. Real life, though—especially with money—runs on footnotes and fine print.

This brings us to the most exalted tidy finance quote: “Risk equals reward.” It sounds like a law of nature, as if every extra ounce of uncertainty automatically delivers a matching ton of profit. It sounds intuitive, but as expressed, it’s not only wrong, but also hazardous to your wealth.

High Risk ≠ High Reward

Many people spend less time and focus on weighing their investment options than researching an airline ticket deal or selecting flooring for their home. Investors who don’t think carefully are prone to making sloppy mental errors… like assuming that risk equals reward. While that “equation” may sound somewhat logical on the surface, it doesn’t take much to realize that taking it literally is ridiculous.

Throwing your cash into a lake or handing it to a stranger on the street won’t yield any financial reward despite the tremendous risks involved. High risk can easily mean low rewards or even a wipeout. For this reason, the best investors tend to be obsessive about managing risks—they may make huge bets, but simultaneously work very hard to tilt the odds in their favor. Warren Buffett’s main objective is to find ways to buy $1 with just 50 cents. The goal is to get the highest possible reward for the lowest possible risk.

Correlation Isn’t Causation

We know sheker ein lo raglayim—there needs to be some truth in any claim for it to persist. And it’s true that, all else being equal, investors demand higher potential rewards as compensation for perceived risks. The US government can borrow money at extremely low rates because the default risk is almost zero. Banks charge very high interest on credit card balances because of the greater risks of providing unsecured loans. There definitely is a strong relationship between financial risk and reward. But that is vastly different from assuming a mathematical certainty in that relationship.

What Are the Odds?

Virtually all investors considering an investment opportunity will ask, “What can I expect to make?” But thinking about potential risk and reward in such simplistic terms masks complex realities. A more sophisticated due diligence approach includes questions like, “What are the risks in this proposed deal, fund, or portfolio?” “How are those risks being mitigated?” and “What’s the worst-case scenario?” The goal is to consider the full risk-reward panorama—the odds of potential gain scenarios versus the odds of potential loss scenarios. Honing in on these odds helps improve investment decisions and outcomes.

The Tortoise Often Wins

Let’s assume, for example, that a crypto “Sillycoin” investment offers a third of a chance of tripling, a third of a chance of remaining flat, and a third of a chance of getting wiped out. If the latter scenario unfolds, you are left with zero, despite the first year’s fantastic growth ($100>$300>$300>$0).

By contrast, say a stereotypical indexed “Boglefund” provides a third of a chance each of either a 15%, 10%, or 5% gain (and an infinitesimal chance of capital loss).

If that unfolds, you would be left with a solid, if unspectacular, 33% gain ($100>$115>$126>$133). In this case, the lower-risk investment provided the greater reward.

Improving the Odds with Diversification

Note that the goal is not necessarily lowering risk per se, but improving the investor’s overall risk-reward ratio. Including some high risk investments in a portfolio can very often pay off.

Assuming the odds cited above, someone who diversified by keeping 90% of their money in Boglefund and 10% in Sillycoin would have ended with a 39% gain, significantly higher than the 33% earned by the investor who kept all their funds in the low-risk Boglefund (the sums calculate to $100>$133>$145>$139). Cashing out 90% of the early Sillycoin successes and investing them in the more conservative option helped the investor significantly increase their gain without ever having risked more than 10% of their capital.

More Reward for Less Risk

Beyond diversification, simple due diligence and logic can also significantly improve risk-reward ratios undertaken by investors. Does a syndicator or fund manager have experience with this investment category, property type, and market segment? What is the quality of the hands-on management team? How secure is the financing package? How much skin do the key players have in the game? How likely or far-fetched are the assumptions? What’s Plan B? Plan C? Is there potential for a large kicker that offers growth beyond most likely projections?

Ignorance Is Real Risk

This reality is contained in a pithy line by Warren Buffett: “Risk comes from not knowing what you’re doing.” Investors with superior knowledge can often make excellent returns with very low risks. If you know, based on your built-up experience and connections, that a particular industry, company, or property is undervalued, you can buy it at prices far beneath its true potential. By understanding the mechanics of good investing, you select managers with far greater potential AND much lower risk of failure.

Tachlis Conclusions

So, building expertise and getting good answers to the right due diligence questions can lower investment risk and increase potential returns. But this type of knowledge and research takes time and effort, and may be beyond the realm or interests of many amateur investors. This is why I recommend that most investors stick to the simplest options. Ignoring these questions and assuming that investments will play out favorably is what the Gemara calls “Hiniach maosav al keren hatzvi.” If you can’t manage the heat, stay out of the kitchen. Otherwise, you’ll probably get burned.