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Financial Literacy | Food for Thought | Why We should Learn Finance?

January 24, 2017

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Financial Literacy | Risk Versus Return (Part2 | Chapter2)

April 3, 2017

 

PART2               KEY PRINCIPLES OF FINANCE

 

CHAPTER2      RISK VERSUS RETURN

 

Kevin is preparing to participate in a White-collar boxing event in Hong Kong. And he asks RJ to be his sparring partner for him before the competition.

 

Kevin offered $50 for the sparring match. RJ accepted the offer and helped his training until the competition.

 

Now, another boxer, Arnold, who is a professional boxer unlike Kevin, also wants RJ to be his sparring partner.

 

How much RJ should ask to Arnold for the sparring match?

 

Probably much more than $50 that he gets paid for Kevin’s match. But why? Let’s think about the risk that RJ is taking in this boxing example. In this case, RJ’s risk is the possibility of getting injured and the degree of the expected pain from the match.

 

Obviously, Kevin is an amateur boxer and smaller than RJ. RJ wouldn’t expect much of injury or pain at the end of the sparring match against Kevin.

 

On the other hand, Arnold is a professional boxer who is much bigger than RJ. RJ expects that he will be beaten a lot, and the possibility of getting injured is high.

 

Therefore, RJ will ask for much more money to Arnold to be his sparring partner, and if Arnold only offers the same rate as Kevin or bit more, RJ probably will not accept the offer. Simply put, as RJ is taking a greater risk against Arnold, he would ask for higher pay.

 

This same principle of risk versus return applies in finance as well. In finance, risk can be defined as “the uncertainty that an investment’s actual return will differ from the expected return”.

 

Although, this is the academic definition of risk, you can just think of it as the possibility of losing your part of your original investments.

 

Simply, what Risk versus Return principle states is that the more risk an investor takes, the higher return that the investor would expect. For example, an investor would expect higher return from investing in equities than keeping his money in his savings account. 

Click here to watch this clip on YouTube.

 

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