When I taught corporate finance at university, I would begin each semester by asking my students to determine if differences in the following two statements have deep meaning or are just semantics.
Statement 1: The greater the potential reward, the greater the risk.
Statement 2: The greater the risk, the greater the expected reward.
Importantly, there is significant difference between these two statements – much more than simple semantics. The first is an assumption. We often assume that where larger potential reward exists, so does increased risk. But this is not an absolute. It is certainly possible to have two investments that present varying potential rewards yet the same amount of risk. Conversely, Statement 2 is an unconditional rule of any adept financial manager; for any astute investor to accept greater risk, we expect larger reward.
Too often we view decisions in myopic terms, looking only at reward. We make a notion that risk is involved, but little actual attention is given it. A shift in mindset allows us to regard our decisions in better light. We no longer see risk as an afterthought that sometimes accompanies reward: risk is the pivot point of any well-made decision. And when this happens – when we make risk the crux of a decision – reward poignantly becomes more than something that may potentially happen, it is expected.
In the financial world, markets punish those who live by Statement 1, as does life. But when we have perspective, we begin to properly assess value and the wiser decision becomes much more clear. That is not to say we should identify risk in order to avoid it – depending on the circumstance, risk can be healthy. However, in our lives, we need to allow an unemotional understanding of risk – not solely reward – to drive decision making. Should you buy that stock? Should you take that new job? Should you leave your spouse? These are all the same question: does the reward warrant the risk?