Risk and return is yet another topic in high finance that you might be surprised to discover you already understand. You get this. Already.
You see, a fund manager will talk about how the underlying risk of a diversified portfolio drives the returns appetite of the investor but… I’m gonna talk about Lisa and Henry.
Lisa and Henry are different people, about as different as people can be.
Let’s pretend that they both asked you for money. A hundred thousand Rand. (Let’s also pretend you have that money.)
Lisa asks first. She wants to use the money to do some basic upgrades on her offices, and pay off some expensive debts. She offers to give you back R110 000 in a year’s time, the extra ten grand being a “thank you” for letting her use your money, and a good reason for you to let her have it.
You’re about to say yes, when Henry leans forward and says “Me! I’d like that too. You’ve got loads of money. Lend me 100k as well – I’ve got a great scheme, been looking for investors, it’s all really exciting, trust me. I’ll give you 110 back in a year’s time.”
If you feel awkward right now, if you somehow don’t want to offer Henry the same deal as Lisa, then I’m happy to confirm that you understand the core principle of risk and return. Lisa is a wonderful person to lend money to. She’s conservative, predictable, works in a profitable industry that’s not going out of business any time soon. Anybody would lend Lisa money, and it’s such a relaxed experience that a mere 10% return (the R10 000 at the end of 12 months) is more than enough incentive to loan her the money (assuming you didn’t have other plans for it).
But Henry is a different story. Henry has some strong points (I mean, he’s more exciting than Lisa) but he’s also kind of flaky. Lending Henry money is an emotional rollercoaster. You’re gonna lie awake, wondering what he’s doing. You’ll see him out on the town, having a great time and you’ll worry that he’s not working hard enough. You’ll be simultaneously excited about his (highly-braggable) prospects, and terrified that he might blow it. That’s natural, and the natural (sane) response is to ask Henry to pay you more for the R100k. Like 50k. Or more. Or a large share of his venture. Or both.
Of course, you’re not the only person who understands risk and reward. Try approaching Lisa with an offer of R100 000 that costs her R50 000 and a large chunk of her dental practice in 1 year’s time, and you’ll be lucky if she doesn’t slap you. Lisa knows she’s a safe bet, she knows you shouldn’t need much compensation for the risk of lending her money.
That’s what interest is meant to be. Compensation for risk. Compensation for sleep lost, for living with the threat of not getting your money back, for not having immediate access to that money if (god forbid) you need it all right now for some kind of emergency.
Between Lisa (low risk) and Henry (high risk) and everybody in between, there’s a pretty clear relationship that emerges between risk and return.
That is the relationship between risk and reward. Stray below that line, to the bottom right corner when Henry asks you for cheap money for a risky venture, you tell Henry to stuff off. Try to go above that line, in the top left corner, offering Lisa expensive money for her very low risk investment, and Lisa will slap you AND tell you to stuff off.
Remember this diagram next time someone tells you that they need your money but they can make you rich and there’s no risk at all. Tattoo it on your hand it if you must.
Risk and return are a balancing act, drawing the fine line between fear and greed. Safe bets yield low rewards. Risky ventures can’t find cheap funding. There are no low-risk, high-return investments.