Risk versus Reward

views updated

Risk versus Reward

What It Means

In economics, “risk” refers to the likelihood that a person will lose money on an investment. An investment is the purchase of an asset for the purpose of earning money. For example, an investor buys shares of stock (units of ownership in a company) with the hope that the company will make money and the value of the stock will rise. If the stock does rise, the investor is rewarded. Stock she purchased for, say, $100 a share is now selling at $120 a share, which means that the investor could, if she wished, sell that stock for a profit. There is no guarantee, however, that the company will make money and cause the value of the stock to rise. If the value of the stock were to dip to $90 per share and the investor were to sell her shares at that point, she would have less money than when she made the investment.

It is generally true that the greater the risk a person takes, the greater the reward he or she will receive if the investment makes money. On the other hand, if an investor only takes a small risk, he or she is likely to earn a small reward. This principle is called the risk/reward trade-off. If a person buys stock in a company that has been stable for decades, such as Coca-Cola, that person assumes little risk. In other words, it is unlikely that the investor will lose money. It is also equally unlikely that the investor will make a lot of money immediately after buying the stock. If that person invests money in a less stable company, for example, a new technology firm, he or she assumes a great risk. The company could go out of business within months, in which case the investor would lose the entire value of his or her investment. The company could also make a great deal of money within a couple of months and one day develop into a major corporation. If that were to happen, the investor could become exceptionally wealthy off a small investment.

It is important to note that individual investors are not the only ones who take financial risks. Banks and other financial institutions take risks when they loan money to individuals and businesses. Likewise, insurance companies take risks when they agree to reimburse their customers in the event of a future loss.

When Did It Begin

People have been taking financial risks since the beginning of commerce, which some anthropologists believe dates as far back as 150,000 years ago. Advanced, in-depth mathematical calculations of risk are relatively new. Two events, one seemingly minor and the other of major historical significance, transformed risk analysis into a complex science. The seemingly minor event was the 1944 publication of Theory of Games and Economic Behavior by mathematician John von Neumann (1903–57) and economist Oskar Morgenstern (1902–77). This book created a field of study called game theory, which is now considered one of the more important areas of research in contemporary economics. Game theory analyzes the complex process by which individuals, competing for scarce resources, attempt to maximize the benefits they receive and minimize the harm they experience. Scholars in this new science calculated risk and reward mathematically with a set of complex equations.

The other event that spurred the development of risk analysis was the Cold War, a 50-year period of tension—though never an open war—between the United States and the Soviet Union. Among many things, the era was characterized by espionage and a nuclear arms race, during which each nation prepared for war with the other. As the Cold War progressed, a process called scenario analysis developed and was employed by leaders of both nations to help them predict outcomes of their military and political decisions. In the 1970s insurance companies began using scenario analysis to calculate the premiums (prices the insured clients are charged) on policies for oil tankers.

More Detailed Information

Most economists and investment advisers use what is called the risk pyramid to demonstrate the relationship between risk and reward. Although renderings of the pyramid vary, the safest investments are always located at the base of the pyramid, and the riskiest investments are grouped at the top. In all drawings of risk pyramids, risks and rewards increase with each ascending tier. Most versions of the pyramid have four tiers, with the foundation consisting of the safest possible investments, which include savings accounts, money market accounts, and Treasury bills.

Money market accounts are savings accounts in which the individual receives a slightly higher rate of interest than is typical in normal savings accounts (interest is the fee earned by keeping money in the account; it is calculated as a percentage of the total amount) in exchange for agreeing to maintain a higher minimum balance than is required by most savings accounts. Some money market accounts place a limit on the number of transactions an individual can perform. Many people do not consider savings and money market accounts to be true investments, even though both do pay interest and therefore make money for the people who hold them. The interest on these accounts is low, and there is virtually no risk of losing money. The benefit of maintaining such an account is that the person has immediate access to the funds in the account. Treasury bills (also called T-bills) are government securities that guarantee the investor a fixed return (usually about 3 percent of the invested amount) after a short period of time. Many economists regard T-bills as the safest form of investment.

The second tier of the risk pyramid consists of a series of relatively safe investment options, although compared to the bottom tier, the risks are greater and the returns are potentially higher. This tier includes conservative stock purchases and balanced mutual funds. An example of a conservative stock would be shares in a stable, long-standing, corporation, such as General Electric. A mutual fund is an investment that combines the money of several investors and purchases a package of stocks, bonds, and other investment securities. There are many different mutual funds available to investors, each posing different degrees of risk. A balanced mutual fund spreads an investor’s money among safe and slightly less conservative stocks. Investors who purchase these relatively low-risk stocks and mutual funds are advised to adopt a “buy and hold” strategy. This means that, after making the initial investment, the investor should expect gradual growth over a long period of time (about 20 or 30 years).

The third tier of the risk pyramid consists of growth funds. Investors at this level put their money into aggressive mutual funds, riskier stocks (such as shares in a start-up technology firm), and investment real estate. An example of investment real estate would be a rental property. Such investors may hold these investments for a long period of time, but they initiate these transactions with the understanding that they may have to sell quickly.

The top tier of the risk pyramid poses the greatest risks for the investor but often pays the highest, most immediate returns. People investing at this level engage in day trading (the buying and selling of high-risk stock in the same day) and purchase commodities (large amounts of bulk goods, such as crude oil, metals, sugar, coffee, and wheat, which are bought and sold through agencies such as the New York Mercantile Exchange). Trading at this level of the risk pyramid is called speculation.

No matter what type of investment an individual makes, there are always two factors to consider when evaluating risk and reward. The first factor is called the time horizon of the investment, which refers to the amount of time the investor wishes to have his or her money tied up in the investment. Some investors prefer to make an original outlay of funds and than add to that outlay at regular intervals. Such investors tend to benefit the most at the second tier of the risk pyramid. The second factor is called the bankroll, which refers to the amount of money the investor can afford to lose. A wealthy investor with millions of dollars of holdings is best served by investing a portion of those holdings aggressively.

Recent Trends

The real estate market experienced a decline beginning in 2006, leading to a drastic increase in the number of foreclosures on both commercial and personal mortgage loans. (A foreclosure is a legal process by which a bank takes possession of a property because the buyer of the property is no longer able to make payments on the mortgage loan he took out to purchase it.) In December 2006 nearly 110,000 Americans were entering some sort of mortgage foreclosure procedure with their lender. According to some statistical accounts, foreclosure rates increased 42 percent between 2005 and 2006. By comparison, in the early 1950s lenders foreclosed on a mere 0.04 percent of the mortgages they authorized.

To combat this dangerous trend, the Federal Reserve (the central banking system of the United States) began scrutinizing the lending practices of all American financial institutions. Initial data on these supervisory reports indicated that lenders were issuing too many faulty loans. It was revealed that, in interviewing customers applying for loans, many lenders were willing to accept the customer’s most optimistic economic forecasts as the likely future scenario. In other words, when these banks asked applicants to predict future earnings, they were willing to accept what were perhaps unsound calculations. As a result, large sums were lent to clients, and both clients and financial institutions assumed irresponsibly high risks. In 2006 the Federal Reserve urged all banks to minimize risks by returning to more sound lending practices.