Risk reward ratio

Posted: Oct 31, 2006 2:36 PM
Risk reward ratio

This ratio is something we all have lived with, and will continue to live with until we are through with our active life. It is something few think about, but it concerns all of us in so many different ways. Let's take a look at what I am talking about.

When we were just little ones, we learned about the fact that in order to get something we wanted, we more or less threw a tantrum. The risk was that if we went too far, we were rebuked instead of being rewarded. The trick needed to turn the ratio in our favor was to learn just how far we could go and still have a positive result. That was our first lesson in the ratio, but not even close to being our last one.

When we became teenagers, we learned about the ratio when it came to the opposite sex. We took the risk of calling our "dream girl" on the phone to ask for a date. In my case, the fear of rejection was so great that it took a self "pep talk" to dial the phone. If I was turned down, I didn't lose money, but my ego took a tremendous hit. During those times I would have rather lost money, but that wasn't what it was all about. The reward was the date, and I found it always seemed to be greater than the risk. After a while, the rejection became less significant, although much too real at times, because the reward got better and better.

Financially, many of us faced the cost of college and found it daunting, even though in my day it was relatively inexpensive. When I graduated from high school, I was offered a surveyor's job for the City that paid $400 a month. The temptation to take the job was great and for a good reason. When I got out of college four years later I got a job at the bank for $300 a month. The decision to pass on the surveyor's job became easier when my father said I was going to college – period. The risk of disobeying my father far outweighed any reward I could think of – period.

Without belaboring the point, one can point to many instances of risk-reward situations that help shape your being without ever thinking of those instances in that way. Which leads me to the main part of the thesis. What is the risk-reward ratio? Why is it important to make use of in our lives? This ratio is a way to determine if risk, especially financial risk, is worthwhile when we compare it to the reward we might get from the action we are contemplating. Basically, how much could we lose from our plan compared to how much we can gain?

The answer is different for everyone. It is dependent upon your psychological makeup and your financial condition at the time. Would you be willing to lose $100 with the reward of making $125? For some, the ratio of return to the amount of risk is too small, while for others it is okay. At some point, as the reward gets larger in relation to the risk, the pendulum swings and fear begins to grow because of the belief that the financial outcome will not be reached.

Two examples at the extremes of the risk-reward ratio are gambling and buying a house. The risk in gambling is great, while the reward, albeit hard to achieve, can be extremely large. This is the reason for the popularity of gambling, which if examined under a risk-reward scenario would probably not make any sense and deter more people than it does. I am not a gambler and I used my own form of analysis when I was much younger at one of my many visits to Las Vegas. The town was continually growing, rooms were inexpensive, food was inexpensive, and liquor was virtually free, so how could this city be growing? The only thing left was gambling and I quickly realized a whole lot of people had to lose for the City to win in the manner it was demonstrating. I chose not to be one of the losers, thus I didn't gamble.

Buying a house was something that made more sense to me. The risk in housing is mitigated in several ways. The first is how you purchase it. I mentioned a few columns ago that my first house was bought without a down payment in an unorthodox way: 80% of the value came from a bank, 10% from a private party lender in the form of a second trust deed and the final 10% came from a client of mine who lent me the money. (As a stockbroker this wasn't something I should have been doing). If I couldn't make the payments, which I knew I could, I would lose the house and owe my client the money he gave me. In losing the house, I wouldn't owe any money on the first mortgage or the second mortgage as they were purchase money mortgages, and a trust deed sale (in California) removed all of the liability.

Obviously the risk was actually zero on that purchase because I had no money of my own in the venture. Once I repaid my client and the second trust deed holder, I had 20% of the value in the house and now I had some risk. I again could guard against loss with insurance to protect me from disasters and through amortization to retire the debt. I could always sell the house if I needed to, but the risk of the value being at least as high as the purchase price was a real one, which fortunately can become less important by simply paying down the mortgage and building more equity.

The difference between the two extremes in the ratio is easy to sum up: manageability. Gambling is hard to manage because it is primarily luck. Housing is much easier because you can control and anticipate the variables that can either lead to a gain or a loss.

I believe that if most people applied this simple ratio to most of their financial endeavors they would be significantly more successful and lead a happier and wealthier lifestyle. Why not give it a try? Figure out what you could lose and compare it to what you could gain. If it makes sense to you and you decide to move forward, at least you know what you are into and have an idea of the outcome.

Most of the time you should be right.