Investment and consumption
Risk and reward introduction
Whenever people talk about investing, the terms risk and reward tend to come up a lot, and they usually tend to come up together. Somehow implying that the more risk you take, the more reward that you might be able to get. And that's actually what it is implying. But what I want to do in this video is give a little bit of an introduction to that, or a little bit of context, and a little bit more structure on how do you think about risk and reward. So let's say that we have $1,000, and we want to figure out what we can do with this $1,000. Well, one option is we could just put it into a savings account. So here is one option. So we could put it into a savings account. And in this situation, our reward-- I'll start with the reward first-- is we'll get-- I don't know-- 1% in interest per year, 1% annual interest. So after a year, we'll have roughly $1,010. We got 1% on our $1,000. So we get a little bit of a reward. What's our risk? So the risk here-- I'll write risk in a different color-- what is the risk here? Well, if I'm putting it into a savings account-- and I'm assuming I'm putting it into an FDIC insured savings account. Let me put that over here. If you do open a savings account, it should be FDIC insured. That means that it's being insured by the Federal Reserve. Which means that if for whatever reason that bank were to fail, below some limit, the Fed will insure your money. So even if this bank fails, and it loses all of its money and everything, you'll still get your deposit back. So if you're investing, or if you're putting money in an FDIC insured savings account, your risk is essentially 0. You are guaranteed to get that $1,000 back, regardless of what happens to that bank. So you have very little risk there. But you might say, look, you know, this is a good risk, but I feel like I can get more than 1% on my money, let me think about the other places that I could invest it. Well, you could-- and obviously I'm not going to be exhaustive on all of the different investment options, I just want to give you a sense of risk and reward. You could say, well, maybe I could lend to the money to a very reputable company. So let me say, lend money to reputable company. And maybe this company has billions and billions of dollars in assets. It's been around for hundreds of years. It generates cash on a regular basis. There's really very few circumstances in which you could imagine that this company would not be able to pay off its debt. And you lend money to a reputable company by essentially buying their bonds. When you buy a company's bonds, you are lending money to that company. So that's just the way you should think about it. So the reward here, if you lend your money to this company, they will pay you 6% in annual interest on your $1,000. So 6% on the first year, you'd get $60. This is six times more than what you were getting in the savings account. What's the risk here? Well, it's not 0 anymore. It's not FDIC insured. The Federal Reserve isn't saying that they'll either give the money if the bank goes out of business, or they'll print the money if they don't even have it. Here, the risk is that the business defaults on the loan. So the company itself might go bankrupt. If it goes bankrupt, then all the people that the company owes money to will go after that company's assets. But maybe you are low on the pecking order, or maybe the company doesn't have enough assets to pay everyone back. So there is some risk. Any business could go out of business, you never know what might happen. But since this is a very reputable company, and as we said it has a lot of assets, it has a very stable business, it does good in boom times and in recessions, this is a low risk of business default. So I'll write, low risk, right over here, because we're assuming it is a reputable company that has a lot of assets, and all the rest. Now let's say that even that 6%, you know, it's all right, but you feel like you could get more. You could do better. So let's say that you have a friend who is a-- let's say that he's just starting his career as a doctor, so he says he has a nice, stable job. So he's just starting his career as a doctor, so stable income. He's making $200,000 a year. But he's just out of medical school, and he figures he wants to buy a house. So he's just starting, and he wants to find people who can help him with the down payment on the house. So here, your reward. And he says, anyone who's willing to lend to me, I will give them 8% annual interest on their money. And it looks pretty good, stable income, it's only $1,000. He's not buying an outlandishly expensive house. He's buying a $200,000 house on which he wants to put a $40,000 down payment. Seems well within his means to pay it. But there's always some risk that he doesn't pay. Who knows? Hopefully this doesn't happen, but maybe something happens to him, himself. Maybe he's not able to work as a doctor. Maybe something happens to his health. Maybe he has of some type of addictive personality, and he likes to drink away all of his money. Or he likes to gamble it away, and that's actually why he needs loans to begin with. So there is some risk. There's a risk that he doesn't pay. But by all indications, he looks like a pretty safe character. But it's definitely riskier than this company, because you have no assets to go after if he doesn't pay. Companies can't randomly get hit by a bus, a human being can. Companies, for the most part, cannot become alcoholics, a human can. Who knows? We don't know. But there are definitely more risks associated with this individual doctor who does not have assets you can go after. But maybe this is also not enough reward. You're like, you know, I heard that I can do even better than this in the stock market. So you look at another option. So let's say you invest in the market. And you're just going to invest in a bunch of-- a broad portfolio, kind of investing in the market as a whole. The reward here would be expected return of the market. So you look at historical results in the market and you say, look it, goes up and down every year. But over long periods of time, it looks like people-- and this isn't the exact number-- but it looks like people have averaged approximately 10% per year. So that looks pretty good, but what's the risk? Well, the risk is that this expectation is just based on what the historical returns in the market were. There are huge periods of time in the market-- I'm talking 10, 20, 30 years where the market is flat. Where the market could even go down. In any given year, the market could go down in the double digits or in the 30 , 40% even, in a really, really bad year. You really aren't sure whether you're going to get your 10% per year. So I would say the risk here is volatility. And volatility just means it could go up and down. It jumps up and down. It's not going to be a constant upward trend, like your savings account will be. Volatility. And you have a good chance that you could actually lose the money that you're investing. It could go down in any year, in any month, in any five years, in any 10 years. So once again, it seems like a kind of risky thing. And you can very easily lose everything. And let's say that even 10% isn't enough for you. You say, hey, I want to look at things that maybe I can get even a better return. So you have your brother-in-law, who's been out of work for a little bit. So let me write the brother-in-law right over here. Your brother-in-law has been out of work for a little bit, and he says that all he needs to start his new guaranteed money making scheme is $1,000, so he can buy the equipment, so that he can start it up in his garage. And the reward-- And there's multiple ways we could set up the reward. We could make it so that he borrows money for you. We could make it so that you own part of the business. So let's say the reward is, you get a 50% stake in the business. And, let's say that your brother-in-law is right, and this becomes a million dollar business. So this is a very, very, very, very high reward, if what your brother-in-law is telling you is correct. But what's the risk? Well, the risk here is obviously that he's not correct and that he squanders all of your money. So lose everything. And not only could you lose the monetary money that you put in, it could also ruin your relationship with your brother-in-law and maybe your spouse. So, risk relationships. Maybe I should put, you risk family happiness. Once your brother-in-law loses all of your money, it won't be so easy at Thanksgiving anymore to have a civil conversation. So in general, the overlying-- I probably did more of these scenarios than I needed to-- but I think you see the general trend. The more risk you take in general, the more of reward you should expect to get. Or the more reward that you're expecting to get, there's probably some risk there. And if there's something that looks like it's really safe with the really high reward, one of those two things are probably not true. So if we were to plot all of these, and I haven't really quantified-- I haven't given you a way of measuring risk. In future videos we can think about that, and academics have thought about ways of measuring risk. So that's risk and reward, if you plot it all over here. So the savings account. It's 0 risk. So this is the savings account over here. It's 0 risk, and your reward is 1%. So this is 1% right over here. The lending to a reputable company. It's a little bit higher risk. So this one right over here. It's a little bit higher risk, and your reward is 6%. So let's say this is 6% right over here. So it's a little bit higher risk. I'm just saying risk is increasing. If you lend to the doctor. So let me pick another color here, that I haven't used. If you lend to the doctor, once again, the risk is a little bit higher than lending to that company or the savings account. Once again, a little bit higher reward. Little bit higher reward. You now have an 8% reward. Investing in the stock market. Let me pick a color I haven't used yet. Investing in the stock market, Once again, higher risk, but also a higher reward. Maybe 10 per year. That's 10% right over there. Your brother-in-law, super high risk, probably off the charts over here, but also super high reward. So maybe it might be like that. But the general idea is, the more risk, the more reward.