Risks and Rewards are not symmetrical

We often hear people say, “There is no payoff without a risk”. It is commonsense. But they further go on to say, “Higher the risk, higher the reward”. Now they tend to equate both risks and rewards. They say you must take higher risks and if you are lucky, you are going to do big in life. Here is where I disagree. Let me explain.

 

Dumb luck won’t reduce risk

Have you heard of people who died taking selfies at dangerous places? They seem to have misjudged the risks and rewards. On the similar line, let us do a thought experiment which all of us can easily understand. Put a bullet randomly in one of the six slots of a revolver and point it to your head and pull the trigger. If nothing happened, bravo, you were lucky. If you want to ride on that luck and take another chance, you also need to realize that your luck would reduce in the next chance, and you can’t be lucky more than five times in a row. Though this was an extreme example, people tend to take chances without understanding the risks they are facing.

 

Risks are difficult to know and quantify in advance

Look at any advertisement, pamphlet or a sales pitch, benefits are written in colorful, bold, and large fonts. How about risks? They are written in fine print. Even if you tried to read it, it is written in a language only lawyers can understand. All those salesmen want you to just ignore the risks, take a leap of faith and just believe what they are saying.

Many a times, it is hard to know what risks we are facing. If we understand the risks by experience or through research, it is difficult to quantify them. Let us say you drive a car. The potential risk is you can meet with an accident. But before the accident happens, you can’t estimate the damage. So, the insurance you have may or may not cover for all expenses. All our risk management exercises are based on estimates only. You will never know the damage beforehand.

 

What the wise say and do?

Warren Buffett, the legendary investor, has a favorite rule for investing. It is “Never lose the money”. His second favorite rule is, “Don’t forget the first rule”. If you don’t want to lose money, you need to understand all the ways and means you would lose money and block or manage each of them. What he meant was, you need to understand the risks well before you plan for an investment. That is more important than understanding the rewards. It is not easy task. But if you want to earn consistent rewards, you will have to manage your risks well.

 

Risks and Rewards are asymmetrical

A lottery ticket you bought for a few rupees can win you an unproportionate sum. Similarly, a small reward of picking coins in front of a steam roller can expose you to a disproportionate risk of losing your life. Risk and reward are not symmetrical in many (or most) cases. As you gain experience and improve your understanding of risks and rewards, you will notice two different combinations of risk-reward payoff. There are high risk, low reward situations. Similarly, there are low risk and high reward scenarios as well. Avoiding high risk and low reward bets is a no brainer. But when your judgment has improved and a low risk - high reward situation presents to you itself (they are difficult to find if you go on searching for them), you want to increase your bets on them. You are likely to receive a huge pay-off from it. They won’t come often but you want to wait for them and play when odds are not against you. Such opportunities do come routinely in all asset classes (Equity, Debt, Commodities and Real Estate). Not only in investments, but such scenario would also present themselves in other walks of life too. All you want to do in the meantime is improving your judgement of assessing the risks and rewards.

 

My journey

I had to lose lots of money, go through emotional pain, and then study various literature on risk to learn the lesson. But I have recovered my losses and doing better now as I am reaching the verge of financial freedom. What helped me the most were teachings of Buffett-Munger duo, podcast of Naval Ravikant and the books of Daniel Kahneman and Nassim Taleb. Learning about risks is counter intuitive, it won’t come easily like understanding of rewards. But without it, forget growing your capital, you are likely to lose it. Don’t be neither a pessimist or optimist, remove all those lenses and see if you can understand the risks as good as rewards of the given situation. If you don’t get a clear picture, it is better let go of the opportunity and continue honing your judgement through extensive reading, deep dive through of various case studies and taking small bets to validate your learning. When you are ready, it will be only a matter of time for the opportunities to present themselves. And the byproduct of better judgement, patience, would also keep you sane and helps you hang on till rewards materialize.

Further Reading, Listening and Watching:

1. Books by Nassim Taleb: Fooled by Randomness, Black Swan and Skin in the Game

2. Books by Daneil Kahneman: Thinking Fast and Slow, Noise

3. Naval Ravikant's podcast: How to Get Rich

4. Videos of Warren Buffett and Charlie Munger