Finance

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Risk

Would you rather have me give you $10 or a raffle ticket with a one-in-a-hundred chance of winning $1,000?  They both have the same expected value, and their expected utility is also probably the same to you.  Your preference reflects your risk attitude. 

Risk plays a very important role in investing and hence in personal finance.  For taking more risk you should be rewarded with more return.  If you had a very large list of investment portfolio alternatives, each with a value for risk and a value for reward, you could plot a graph with risk on one axis and return on the other.  You'd put a point on the graph for every alternative investment scenario.   Then you could methodically look at each value on the risk axis and find the point with the best return for that risk.  Connecting those points creates a special boundary line called the Efficient Frontier.  Points not on that frontier are poor choices, or bad scenarios--because you can find another point (on the frontier) that has either a better return for the same risk, or a lower risk for the same return.

One way to reduce risk is to diversify, that is: don't put all your eggs in one basket.  Mutual Funds purchase a mix of securities (stocks, bonds) to provide diversification to investors.  Some investors put money into different mutual funds to further diversify their investments.   However, if they aren't careful they may find out that the different mutual funds had a lot of stocks in common (or stocks that tend to go up or down together)...and they really aren't as diversified as they thought.

Also remember that risk is reduced by the number of independent events that result in a payoff.  If we flip a fair coin once for $100 you either win it all or get nothing.  But if we agree to do it 100 times for $1 each the results will be much different, though still uncertain.  If you have the same stock in 10 different brokerage accounts, you outcomes are not independent, of course.

 

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© 2003 Michael E. Doherty