❝There's no such thing as a free lunch.❞ -Milton Friedman
Are you familiar with real estate TV shows? In these shows, the host buys cheap houses, fixes them up, and resells them. They often show a running total of the expenses that went into the house and then show you the profit that was made at the end. These are reality programs that glorify house-flipping.
Sometimes, these hosts go on tour, hosting seminars on how to flip houses yourself. Sometimes they charge you money for the course or seminar. Other times, they lure you there with a free meal.
All of this sounds similar to commercials that can be heard on local talk radio stations where a loud, enthusiastic person comes on talking about how easy it is to flip houses. All you have to do is follow the system, and you will be on your way to riches.
There’s one thing that these folks don’t tell you about, though. It’s also the same thing that they have been trying to hide from you. There is risk. There is always risk.
At its most basic level, risk is the chance that something will not happen as you hoped. If you are a hiker, you might twist your ankle on a difficult part of the trail. In the world of investing, you can think of risk as getting a return on your investment that isn’t as high as you hoped (or even losing money). In real estate, risk can mean a lot of things; maybe you can’t find a buyer, you can’t get the price you thought you would, or a city or county rule you to know about could prevent you from fixing up that “fixer-upper” the way you wanted.
In finance, we often talk in terms of probabilities. Although, it doesn’t need to be an investment or anything finance-related. When you take an action, there is a result that you expect. What actually happens is more likely around that expected result and resembles a bell curve.
Risk, then, is the chance that what actually happens will be less desirable than what you expected to happen. Back to the world of investing, this is getting a return that’s less than you expected. If I’m driving to work and expect to take thirty minutes, this would be the commute taking forty-five minutes.
The math behind finance technically defines any deviation from expected results as risk. Therefore, technically speaking, it’s called risk if something happens that’s better than what you expected.
However, I’ve never heard anybody complain about getting a better result than they hoped for. Author Morgan Housel agrees in his book The Psychology of Money, where he defines getting a better result than expected as luck. But it is the same concept.
RISK AND REWARD
Now, the expected result (or reward) and the chance that you don’t get that expected result (risk) are two sides of the same coin. There is no reward without risk. Said another way, obtaining a reward requires taking some sort of risk.
For example, if I want to go 35 miles per hour down the hill on my bike (which is really fun), I might wipe out. That risk is always there. If I don’t want to wipe out, I shouldn’t ride my bike that fast.
If I don’t want to get into a car accident, I don’t have to drive, but then I can’t get to work or the grocery store. Once I get into my car, I risk getting into a car accident.
If I want a higher return on my investments, I can invest my money in stocks, but my investments could go down when I need to sell them. If I stay out of the stock market, I can’t get a return that helps grow my money as fast.
The risk is always there, and we can choose which risk we accept. Investing in the stock market puts me at risk of losing money if I have to sell. Not investing in the stock market puts me at risk of my money not being worth as much because of inflation. It’s a different kind of risk, but every scenario has risk. As Thomas Sowell said, “There are no solutions, only trade-offs.” The trick is knowing what you are trading off.
RISK AND REWARD ARE ALWAYS RELATED
The risk/reward coin can be plotted on a graph. The lower the risk, the lower the reward. This is fine for people who don’t want to subject themselves to risk, but they can’t expect much reward in exchange.
As you move up the curve, you take more and more risk. The compensation for taking that risk is a higher potential reward.
So far, I’ve been talking about risk that has a payoff. It is possible to subject yourself to risk that doesn’t have any opportunity for any type of reward. As a silly example, I might jump off my roof just to see if I can land on my feet. This is an enormous amount of risk that has no upside. This is a dumb risk to take.
On the other side of the curve is the realm of tooth fairies and leprechauns. This zone doesn’t exist. This is the zone that is easy to sell, though. This is the zone ads pitch to you to get you to buy some sort of system. It’s easy to sell because it’s what we want to hear. It’s easy to sell somebody the dream that you can reap some rewards without taking risks.
Yet, because it doesn’t exist, if it seems like there’s an opportunity that has a lot of upside with no risk, then either it is a fraud, or you don’t know what the risk is. In either case, it’s best to stay away.
QUESTIONING THE MOTIVATION
Imagine for a minute that you have a money-making secret. This can be a house-flipping method you thought of or some way to make a killing in the stock market. If your goal is to make money, you would simply keep this method a secret and make your money – over and over again. What benefit would you get from selling it to me? If you sold it to me, I would now be competing with you for profits.
It's valuable to think this way if somebody presents you with a money-making opportunity that seems too good to be true. I've seen a program about a guy in Las Vegas who sold a machine that can predict Keno outcomes. Of course, this can't be done, but nonetheless, he was able to charge $500 for these machines. He promised a get-rich-quick scheme that so many of us find irresistible.
Viewed through this lens, you can now ask yourself questions like, "If this person can use this thing to make $10,000 in a weekend, why would they sell it to me for $500?" This can shed some light on what their motivation might be.
The temptation may always be there to earn a quick buck, especially if it seems risk-free. But risk-free doesn't exist.
Always cover your wallet if you hear someone talking about something that seems too good to be true. And run away if they claim their reward comes without risk.
You get one life; live intentionally.
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REFERENCES AND INFLUENCES
Ariely, Dan & Jeff Kreisler: Dollars and Sense Bernstein, William: The Four Pillars of Investing Clements, Jonathan: How to Think About Money Ellis, Charles: Winning the Loser’s Game Gibson, Roger & Christopher Sidoni: Asset Allocation Hagen, Derek: Your Money, Your Values, and Your Life Housel, Morgan: The Psychology of Money Zweig, Jason: Your Money and Your Brain