Risk hai toh ishq hai

Translation: If risk then there is love.

That is the direct translation. Taken from the web series “Scam 1992”.

It can be interpreted as if there is risk, then life can be lived to fullest.

If you drive bike at around 120km/hr then there is risk. The expectation/return is fun, and your resource is… you. The higher the speed, the more fun is expected.

In worst case, you get into accident and end up in hospital.

There are four components here:

• Activity → riding at high speed.
• Expectation → fun.
• Resource → you.
• Risk → landing to hospital.

The risk is extremely high for a short period of fun. That’s a trade-off I will always avoid.

The risk can however be reduced by putting up constraints.

Instead of riding at high speed in busy traffic, I go to a racing track. Then I wear professional gears, helmet, jacket, guards etc. I change my bike tyre to soft so that it sticks more while turning.

My expectation, resource and activity is mostly the same but I have now significantly reduced the risk of landing to hospital.

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Rule of Thumb.

A good heuristic (rule of thumb) is to consider risk and reward as proportional. Meaning if risk is high so will be the reward. And if risk is low reward will be low too. They are different side of the same coin.

If proportion comes into picture, there must be a constant too.

The constant or C while riding my bike is the environment in which I am riding my bike. By putting the constraints of a professional bike racing setup, I made the C as negative. So the risk is reduced.

I can use other methods to reduce C too. I can drive a slower bike or put a limit to speed. I can use a better bike with greater capabilities like higher breaking power, wider tyre.

Risk can be then:

As I make the constant(s) more negative, the lesser the risk becomes without changing much of my expectation and resource.

Now I am more likely to ride the bike in high speed.

In financial investing, risk is mostly associated with permanent loss of capital. And expectation is return.

It can be different too. If liquidity (the ease of your capital employed to be converted to cash) is your highest priority, your expectation is liquidity and not return. Or it could be to just beat inflation. In these cases, risk associated automatically becomes low.

Most trouble comes when investor chase high return by employing capital in risky assets.

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Wait a minute

But hold on.

We have been talking about “risk” and we just saw how risk and reward are related. But what exactly is it?

In a sentence, risk is an outcome you don’t want.

And similarly, reward is an outcome you want.

In investing risk is the expectation you don’t want when you put your resource to work. Permanent loss of capital, not beating inflation, not cracking the exam after preparation etc.

When you invest in index fund (the entire market) the risk is minimal and the reward is average. Don’t let that concern you since most of the mutual fund fail to beat index fund. If you invest in index fund for the long game, you get “average return” but it is not so average if you compare with all mutual funds.

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Conclusion

Reward and risk are different sides of the same coin
We saw how risk and reward are related. They are different sides of the same coin. As an investor your job is to reduce the risk associated with your expectations.

If your expectations are low, your risk automatically becomes low. You don’t need to put much effort into reducing your risk in this case.

On the other hand if your expectations are high, your risk becomes high. Then you need to put more effort into reducing your risk.

In sum to reduce risk, you have to make these constants as negative as possible.

That’s it for today.