NSE #5: Risk and Reward, the truth

, , No Comments
Nearly all Nigerians I have met have a wrong perception of the risk and reward relationship. I used to get it wrong too, till I read an MBA Corporate Finance textbook. 

image: gamedevwithoutacause.com 

We all know that Risk is the possibility of your investment declining in value. 

We also know that Reward is the money we earn on top of our original investment. The proper financial term is Return. 

Where the error lies is in our believe that more Risk always equal more Reward. It's not that the statement is false, but that it's incomplete. The complete statement is -- In an efficient market, more risk equals more potential reward.
Note the words in bold. They make all the difference in the investment world.

An efficient market is one where all relevant knowledge about the merchandise are available and known by everyone. It's like the market for pure water in Lagos; everyone knows the price of pure water and what it looks like. There is no knowledge gap to exploit. 

Potential reward simply means possible reward, not sure reward.

So what's the truth about their relationship?

When taking a risk, it should be in a venture you have all the available information about. One you are extremely knowledgeable about. And in the investment world, you're better off in a venture that has an efficient market. It's only then that you can say the money money I risk/put in this venture, the more reward/return I will likely get.

In one of the subsequent posts, I will discuss how to estimate risk and put some numbers on it. I will explain the concept of risk-free rate of return and risk premium.


Post a Comment

You can be sure of a response, a very relevant one too!

Click on Subscribe by Email just down below the comment box so you'll be notified of my response.