Jim and Marilyn are a delightful retired couple who are waiting at my local bagel shop for it to open at 5:30am every morning from Monday-Saturday. They take an early morning walk there for coffee. Marilyn has a cookie; Jim eats a toasted bagel. I see them when I am running late and can stop in on my way to the office.
Early on Sunday mornings they eschew the bagel shop and drive to a local casino to wager $100 each (usually on slots) after having breakfast. When I see them on Mondays, I always ask how they did, and so far (over a pretty significant sample size), they have yet to claim to have done worse than breaking even (“after paying for breakfast”).
Since slot machines typically have a pay-out percentage in excess of 90 percent, that level of good luck is possible, if unlikely. I suspect they fudge a bit, in the same way gamblers generally (and investors too!) remember when they win and forget when they lose. Moreover, (also like investors, although it applies to investors to a lesser extent), gamblers perceive an “illusion of control” — the belief that they can exert skill over an outcome that is actually defined by chance and are overconfident in their abilities generally.
Of course, despite what gamblers would like to think, the odds are always meticulously arranged to ensure a steady profit for the casino in the aggregate if not in the particular. Those huge and expensively appointed buildings are built on and for those profits.
In a similar way, risk and reward generally correlate in the investing world. Low risk usually goes along with low potential returns and high returns generally require high risks. Money for nothing is a very rare thing indeed.
Characteristically, investment scams almost always either dramatically understate the risks or dramatically overstate the gain potential of the proposed offering — and often both.
Mispricing is an opportunity of course. When risk and reward are out of whack, smart investors take advantage. As every good value investor is well aware, securities are either undervalued, fairly valued or overvalued. Generally speaking, the first category should be bought, the second held and the third sold. But if and when something seems too good to be true, it usually is. If you are promised a seemingly disproportionate return for little or no risk, check your wallet — it’s likely a scam.
Keep reminding yourself that risk and return generally correlate. It is the foundational key to risk management.
My series on risk is available at these links:
- Reckoning with Risk (1) begins to look at how to deal with risk.
- Reckoning with Risk (2) explains and categorizes different elements and types of risk.
- Reckoning with Risk (3) shows our failings at dealing with low-probability, high-impact events.
- Reckoning with Risk (4) looks at what the Yale Endowment experience can teach us about risk.
- Reckoning with Risk (5) explains that professional managers face different risks than those for whom they manage money and that those differences matter.
- Reckoning with Risk (6): 9.11 Edition takes a look at “black swan” risks.
- Reckoning with Risk (7): Widening Your Lens suggests that dealing with risk requires that you actively manage your life.
- Reckoning with Risk (8): Risk Capacity, Appetite, Tolerance and Perception looks at the problem of (apparent) shifts in risk tolerance.
- Reckoning with Risk (9): Money for Nothing reminds us that risk and return generally correlate.