The Risk/Return Ratio

By: Bernd Wechner
© June 1, 1998

The Risk/Return Ratio

The Risk/Return Ratio

Author: Bernd Wechner
Published on: June 1, 1998

If you've ever had any money to invest, you probably looked at the options available. You will have found bank accounts, bonds, stocks and more, and there were only two or three important factors you would have used to choose between them. Well, in classical theory, there are two big ones. One is the promised return on your investment (how much money you'll make) and the financial risk (what chance you have of not making the promised return or of losing your money altogether).

There's a third practical factor, namely the work required to effect the investment, in the way of research, talking to agents and so on. In reality this last factor keeps most of us using bank accounts - that with which we're familiar. This last factor is, practically speaking, the cost of the investment. If the cost is purely financial, it kind of melts into the return, and we're left with those two classical factors, risk and return. If you have large sums of money and motivation to invest wisely, or are just very good at investing, that's generally what happens in my experience - that is, the non-financial costs (your time, energy, motivation, worry and so on) aren't very high when compared to the large sum of money at hand. Hence, it's not much talked about. Risk and return are.

In practice you'll find that risk and return are, in what we call a free market (just another imaginary beast really, but let's not sidetrack too much), strongly related. The higher the return, the higher the risk.

On one end of the scale you have very secure investments, which are government-backed. Your chances of losing your money are slim; in fact, effectively zero, as the governement secures it (not that governments are immune from bankruptcy, but they're not especially susceptible - we should hope). The return on these secure investments is appropriately low.

On the other end of the scale you have investments promising a high return. These are most commonly stock in small promising companies, the sort of stocks that rise in price fast ... if at all. That is, the risk is also high.

Well, it's a natural phenomenon, really. If you're looking to attract investment, or if you need money for a project, you have to promise the investors a return which matches their perceived risk of your venture, basically. Financially we speak of a risk/return ratio, which is among all investments relatively similar - it is forced to be, by a freely operating market. If a high-return, low-risk investment existed, say, then everyone would buy it, the cost would rise, and the return drop. If a high-risk, low-return investment existed, no-one would buy it, the cost would drop, and the return would rise. Of course, no market is entirely free, being a little obscured by the uneven flow of information (meaning only that for a short moment high-return, low-risk options pop up, until everyone notices!).

Further, in financial circles we speak of minimising risks (through sensible portfolio management for example) and of risk profiles (whether you favor high risk and high return, or whether you favor low risk and low return, or a balanced mix of the two). Notably, risk is not measurable, it describes unknown future events, and whenever the term risk is used the implicit adjective "perceived" is tacked onto it. That is, we speak of perceived risks. As a matter of fact, it is this subjective assesment of risks that lies at the bottom of stock market instabilities. As the public perception sways, so too can the flow of money, independently of any underlying physical phenomena.

So? What of risk and return (and cost)? Are we reading a financial column here?

Well, it's my experience that everything discussed thus far applies to life in general, not merely to our finances. They are most often introduced in a financial context, and most of us I suspect are familiar to some degree with them in that context. That may well be a sign of our money-centric societies, who knows, but I'm presenting them here, not out of context, but in their vaster context. I've used a financial introduction in the hope that it sounds familar and plausible to most people I guess. Having established the working principle I'll broaden the application a little.

Consider this: anything you do in life, be it investing money, having children, going for a walk, borrowing a video, reading a book, playing a game, eating, breathing, or even sleeping - I mean anything and everything you do - you subject to these very same selection criteria, be it conscious or subconscious.

You want to know whether it will fulfil expectations, whether you'll enjoy it, what it will cost (not just in terms of money, but time, energy, nerves and anything else we can give), what the chances are it will turn out to disappoint, bore, cost too much and so on ... that is, you're balancing up the risk/return ratio for starters, and then deciding if it fits your wants. People gravitate towards certain risk profiles - some sit at home and watch videos, others go hang gliding, yet others read a lot and sky-dive a little. So everyone puts together a portfolio - so to speak - of varying risks and returns to achieve a tolerable net level of risk and return, all the while minimising unnecessary risks. They need to fly high once in a while, or life's not worth living for them, but they don't need to put their lives on the line all of the day every day either.

In fact, we do everything the investment agent does, we just do it with more qualitative measures than money alone, and we do it on the fly, getting better at it as we go, finding the things we like (high returns) and avoiding others (low returns). The returns are measured in relation to the risk and the cost (cost becomes a factor as it's often measured through qualities different to the returns - in the financial world, where costs and returns are both expressed in dollars, they can generally be lumped together).

So what does this have to do with hitch-hiking? Well, hitch-hiking, like everything else, is subject to the same assesments of risk, return and cost. Risk of course wins all the attention, and needs no voice here. The returns I've been presenting in these columns on a monthly basis since October 1996, and the costs are fairly clear as well (you may have to wait, in the cold and the rain, for a ride ... costing you time, and comfort).

Whether we hitch or not depends primarily upon our assessment of the risk/return ratio. If we see the risks as too high for the returns, we will avoid it; if we see the risks and returns as well matched, we may do it, and if we see the returns as very high given the risks, we flock to it. It all has to do with the perceived risk/return ratio (and to some degree the costs, though for convenience sake I could lump them together with the returns as well. Let's think of net returns after costs).

As in the financial world the risks are perceived - there is no objective measure. It's worth noting, though, that it is more possible to measure hitch-hiking risks objectively than financial risks. I say "more possible" because with regards hitch-hiking we can look into the past and see how risky it was. The link between past experience and future expectations is fairly strong. In the financial world that is much less true (though not altogether untrue). Still, regarding hitch-hiking, while it may in principle be more possible, it isn't possible to date, because of incomplete records (we'd need to collect a lot of data on how many people hitch where and how far, and what kind of troubles they have - something that's only been haphazardly tried in the past, and is, practically speaking, rather impossible to do completely).

Well, it was my aim to introduce the concept of risk/return, or risk portfolios and of perceived risks and how these apply to hitch-hiking. People subscribe to different risk portfolios in their lives (from playing chess to sky-diving say). Also, for any level of risk, if the returns are there to match, people will embrace it. Risks and returns are perceived differently by all of us, which is partly why we engage in such a diverse range of activities ...

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