Investment Risk Versus Reward: Navigating the Complex Relationship

December 14, 2021

Investing, Stocks

Moshe Langer kept investing… and losing. He had figured that if risk equals reward, he was best off taking a lot of financial risk to gain the most reward. But so far this strategy was failing. The $50,000 he’d given his nephew, who was just starting out in real estate, had evaporated. Then, his $25,000 bet on Sillycoin, a brand-new cryptocurrency promoted on LinkedIn, had disappeared when the coin had proven worthy of its name. Now, his final $25,000 was invested in Tesla stock, which had plummeted by 10% soon after his purchase.

Clearly, taking huge risks wasn’t bringing Moshe his expected rewards. What’s wrong with his investment approach?

High Risk ≠ High Reward. Low Risk ≠ Low 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 that don’t think carefully are prone to making sloppy mental errors such as 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 getting 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 Moishe’s 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, he is left with zero, despite the first year’s fantastic growth ($100>$300>$300>$0). By contrast, a stereotypical 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, Moshe 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

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 his funds in the low risk Boglefund. Cashing out 90% of the early Sillycoin successes and investing them in the more conservative option helped the investor greatly increase their gain without ever having risked more than 10% of their capital ($100>$133>$145>$139).

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, type of property, and market segment? What is the quality of the hands-on management team? How secure is the financing package? How much skin in the game do the key players have? 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? Getting good answers to these questions can lower investment risk and increase potential returns.

But this type of due diligence is work, and may be beyond the realm or interests of many amateur investors. This is why I tend to recommend that they stick to the simplest options. To my mind, ignoring these questions and just 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.