I am going to teach you about Risk vs Return

This blog is called  “Food Finance Travel”, but I have never posted about finance so this will be the first.  Depending on the reception, I will post more in the future.

Today I will teach you about how to think about risk and return.

Basically, the higher the risk you take, the higher your expected return should be.

Lets take a simple Treasury Bill.  A Treasury Bill is a debt obligation of the U.S. Government.  Just like a person or company, when the government spends more than it earns (taxes collected), it has to finance the difference by borrowing. 

So lets say today, the U.S. Government asks you to lend it $100, and in return it will pay you 3% over one year.  Therefore, at the end of the year, they will give you back your $100 PLUS $3 in interest.  These are the basics of a T-Bill, and since the U.S. Government has a miniscule chance of defaulting on its debt obligation to you (because it can print money, raise taxes etc), a T-Bill is considered risk free. 

Now lets say I ask you to lend me $100 for one year and offer to pay you $103 next year.  Would you accept?  Maybe if we were close friends or family, but most likely not.  I am offering you the same rate as the U.S. Government, but I carry more risk of paying you back than the U.S. government.  Therefore, I would HAVE to offer you more than 3% to compensate you for that risk.  There is some rate that you will accept for taking on that risk, maybe I would have to offer you 5%, 6%, 7% etc. 

Now you see why the higher the risk, the more return is expected.  So far we have been talking about debt obligations.  Lets take a look at equities or stocks now.

In general, a stock is riskier than a debt obligation (T-Bills, Bonds etc).  The reason is that debt HAS to be repaid by the borrower contractually.  When you buy stock in a company, your claim on the company comes after the debt holders are repaid.  You take on the most risk, but also have the highest upside potential.

Lets look at this in the context of a home.  Lets say you purchase a home with a value of $100 and financed the purchase with 50% debt (a $50 mortgage) and 50% equity (you put $50 down in cash).  Lets look at what happens to the value of your $50 investment under various scenarios (ignore interest on the debt).

House price falls to $75 – if the value of the house falls to $75, and you sell it, you will take the $75 and give $50 to the bank to pay off the mortgage.  You will then pocket the remaining $25.  However, you initially put $50 into the house.  Therefore, the $25 drop in the value of the house is borne entirely by you, the equity holder (owner).

House price rises to $125 – if the value of the house rises to $125, and you sell it, you will take $50 and give it to the bank to pay back the mortgage.  You will then have $75 left over.  You originally put $50 in so the entire increase in the value of the house ($25) is yours.

As you can see in the above examples, equity (stockholders in the case of a company), take on all the risk.  Debt holders get paid first.  Therefore, equity holders have a higher expected return than debt holders.  If you look at the long run return on different assets, this is certainly the case; stocks have outperformed bonds in the long run. 

Going further along this line of thinking, within stocks, risky more volatile companies will have a higher expected return than larger more stable companies (blue chips).  Take for example the expected return on a large company like Apple vs a small but promising tech start up.  The only reason someone would invest in the tech start up over Apple is if they expected the return to be higher than the expected return on Apple.

This post should give you a good basic understanding of how to think about risk vs return.  Although it was overly simplified, and there other factors involved, it gives a good foundation for us to move on to other topics in the future.  If you liked this post, and learned from it, like, subscribe and comment below on what you want to see more of or if you have any questions about finance! 

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