At its most basic level, risk is the chance that something will not happen as you hoped.
If you're a hiker, you might twist your ankle on a difficult part of the trail.
But with money, risk isn’t just a number; it’s a fundamental part of every choice we make.
Take investing, where you can think of risk as getting a return on your investment that isn’t as high as you hoped (or even losing money).
In property, maybe you can’t find a buyer, or you can’t get the price you thought you would.
With anything, when you take an action, there's a result that you expect.
The actual result is then likely compared to that expected result, and this can be shown on a bell curve.
Risk, then, is the chance that what actually happens will be less desirable than what you expected to happen.
In investing, this could be getting a return that’s less than you expected.
If I’m cycling to work and expect it to take thirty minutes, this would be the commute taking forty-five minutes.
The maths behind finance technically defines any deviation from expected results as risk.
Therefore, technically speaking, it’s also called risk if something happens that’s better than what you expected.
However, I’ve never heard anybody complain about getting a better result than they hoped for.
Author Morgan Housel agrees in his book The Psychology of Money, where he defines getting a better result than expected as luck.
But it's the same concept.
Risk and reward
Now, the expected result (or reward) and the chance that you don’t get that expected result (risk) are two sides of the same coin.
There's no reward without risk.
Said another way,getting a reward requires taking some sort of risk.
For example, if I want to go 35 miles per hour down hill on my bike ride to work (which is really fun), I might fall off.
That risk is always there.
If I don’t want to fall off, I shouldn’t ride my bike that fast.
If I don’t want to get into a car accident, I don’t have to drive, but then I can’t get to places I might want to go.
Once I get into my car, I risk getting into a car accident.
If I want a higher return on my investments, I can invest my money in the great companies of the world (the stock market), but my investments could go down as well as up.
If I stay out of the stock market completely, I can’t experience the returns rewarded to those willing to take on the price of admission (the risk).
The risk is always there, and we can choose which risk we accept.
Investing in the stock market puts me at risk of losing money (if I sell).
Not investing in the stock market puts me at risk of my money not being worth as much because of inflation.
It’s a different kind of risk, but every scenario has risk.
As Thomas Sowell said, “There are no solutions, only trade-offs.” The trick is knowing what you are trading off.
Risk and reward are always related
The risk/reward coin can be plotted on a graph.
The lower the risk, the lower the reward.
This is fine for people who don’t want to subject themselves to risk, but they can’t expect much reward in exchange.
As you move up the curve, you take more and more risk.
The compensation for taking that risk is a higher potential reward.
So far, I’ve been talking about risk that has a payoff.
It's possible to subject yourself to risk that doesn’t have any opportunity for any type of reward.
As a silly example, I might jump off my roof just to see if I can land on my feet. This is an enormous amount of risk that has no upside (other than proving to myself or others I can do it).
This is a dumb risk to take.
On the other side of the curve is the realm of tooth fairies and leprechauns.
Of guaranteed and sky-high investment returns, that are risk free.
This zone doesn’t exist.
This is the zone that's easy to sell, though.
This is the zone pitched to you to get you to buy some sort of system.
It’s easy to sell because it’s what we want to hear.
It’s easy to sell somebody the dream that you can reap some rewards without taking risks.
Yet, because it doesn’t exist, if it seems like there’s an opportunity that has a lot of upside with no risk, then either it's a fraud, or you don’t know what the risk is.
In either case, it’s best to stay away.
Questioning the motivation
Imagine for a minute that you have a money-making secret.
Say, some way to make a killing in the stock market.
If your goal is to make money, you would simply keep this method a secret and make your money – over and over again.
What benefit would you get from selling it to me?
If you sold it to me, I would now be competing with you for profits.
It's valuable to think this way if somebody presents you with a money-making opportunity that seems too good to be true.
I once read about a man in Las Vegas who sold a machine that can predict outcomes of the Keno numbers game.
Of course, this can't be done, but nonetheless, he was able to charge $500 for these machines.
He promised a get-rich-quick scheme that so many of us find irresistible.
Viewed through this lens, you can now ask yourself questions like,
"If this person can use this thing to make $10,000 in a weekend, why would they sell it to me for $500?"
This can shed some light on what their motivation might be.
The temptation may always be there to earn a quick buck, especially if it seems risk-free.
But risk-free doesn't exist.
Always cover your wallet if you hear someone talking about something that seems too good to be true.
And run away if they claim their reward comes without risk.
