My Investing Journey with Passive Income and Stock Market investing

Risk vs. Reward

Does Risk really equal reward?

We’ve all heard the old saying, “Risk equals reward.” While some level of risk is usually involved in many of life’s rewards, it’s simply not always true that greater risk equals greater rewards. In fact, greater risks can often lead to greater losses.

Sometimes losses aren’t difficult to recuperate from; however, when it comes to our finances, a huge loss may take years to recover from. In particular, those with lower income may find a financial loss particularly devastating. Unfortunately, it’s they who have little that often desperately take on foolish risks, an attempt to create a new world for themselves. I believe an investment choice should begin with a look at Risk vs. Reward.

You can peruse the internet for people that lost tens of thousands of dollars in cryptocurrency bets or visit Wallstreetbets Reddit below if you want to see some entertaining results of stock gambling:

You don’t have to go far to see the damage lots of leverage can do when the market turns sour. If the market goes down, you now lose twice as much or how much ever you’re leveraged. The greater the risk (the greater the leverage) the more you lose! Why do people only want to see one side of the equation here?

The idea of greater risk means greater rewards is easily disproved:

Take a lottery ticket, maybe a scratch-off that costs $5.00. Even though it only costs $5.00, you could stand to win tens of thousands. The reward is a lot but the risk is very little. Take your state lotto, now we are up in the millions but you can buy a ticket for $1.00. The reward is huge but once again, the risk here is very low. At the same time, as you buy more and more tickets you don’t suddenly gain more and more rewards. Most likely you end up with greater and greater losses.

The next time you get in your car increase the speed. As you increase the speed, does your reward or risk increase? I think your local police officer would agree that as the risk goes up, the reward goes down.

Now a personal example:

In October of 2018 I bought a Long-term bond fund; there for awhile this fund was beating the market. This bond fund was not a risky proposition or volatile relative to the equities market. In fact, it was less volatile and carried less risk.

If risk equals reward then how do you explain such an investment vehicle outperforming equities? Only as of a few weeks, the market began outperforming my bond fund by a few percentage points since October. However, this could change at any point. If the bull market suddenly turns into a bear market and my bond fund starts outperforming the S&P again, is it simply because it got riskier? Of course not, the idea is ludicrous.

Let’s go further-think about an Adrenalin junkie. The more you exposure yourself to risky behaviors the more likely statistics won’t be on your side. For instance, if you jump out of enough airplanes, rock climb without a rope or bungee jump enough times; sooner or later face meets the ground and you’re now a pancake. Maybe it’s just me but I’d rather not tempt fate.

It’s not hard to imagine countless scenarios where as the level of risk increases, the more dangerous it becomes and the more you stand to lose. Chasing greater beta and risks for some imaginary return is akin to playing with fire and hoping not to get burned.

These are some ideas I had contemplated before not only about investing but life and then I happened on this gem of a book by Eric Falkenstein about risk and low volatility investing. It expands on these ideas and goes further to prove just how ridiculous the notion of risk equals rewards truly is.

“The Missing Risk Premium:Why low volatility investing works”

This book is not meant for an investing beginner as he gets heavy on the jargon.

Here is a video interview he did that summarizes a few of these points:

Summarizing Eric’s thoughts:

Stocks with high Betas and greater volatility historically don’t outperform the market, they underperform.

What does Eric say a high beta is? A beta of 1.5 is a nice cut-off when it comes to equities. Avoid such risky stocks/funds/bonds, they provide no risk premium.

These risks don’t exist with equities alone. For instance, take your junk bonds versus say an investment grade bond or BBB bond. A junk bond has a poor historic return over an extended period of time in comparison to the investment grade bonds.

His overall theme is that no premium risk factor exists for most investments as previously thought.

Here is my youtube video where I summarized my own thoughts and feelings about this idea:

I am certainly not saying don’t take risks as any investment comes with risks. I am simply saying the risk to reward curve is not linear, at some point it starts to be negatively correlated and you are paying more for extra losses.


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1 Comment

  1. Jody

    I would love to hear from you about your experiences with risk vs. reward. Perhaps some investments you lost on or even investments you took lots of risk on and they worked out for you?

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