Understanding Risk and Reward
Updated: May 20, 2019
Why does a drug company have very high returns?
Because developing a new drug is a high-risk venture. A drug must work consistently, have tolerable side effects and then go through an extensive approval process. Under the current patent process, companies only get 12 years to recover their investment. So, this is an extremely high Risk proposition.
Understanding Risk is at the heart of decision making. Unfortunately, we spend very little time talking about Risk and understanding how to mitigate it. If anything, we are told to avoid Risk.
But in order to get a return above that a of U.S. Treasury Bill (considered the "Risk Free" return) you need to take Risk. There is no such thing as a Risk Free 10% return.
Understanding Risk is critical to making allocation decisions. The trick is to make sure the reward (return) is commensurate with the Risk. Smart investors minimize their Risk through good due diligence and certain "inside" knowledge.
One example of understanding Risk is though gambling. When you bet on something there are odds to win or lose. The higher the odds, the more Risk.
Betting on a horse with 10-1 odds is much more risky than betting on a horse with 2-1 odds but if the horse with lower odds wins, there will be a greater return. The betting action determines the odds so there is a supply and demand aspect to it.
Many decisions organizations face don't have odds associated with them. An organization must clearly identify their desired return as well as the required investment and the risks associated with that return.
For instance, deciding to expand internationally might have a high reward but there are substantial risks in trying to globalize a product or service - not the least of which are cultural differences, regulations and start-up costs. All this must be understood before you make the GO decision. Once the risks are understood, they can be mitigated.
Taking more risk means a higher return but it's important to make sure your expected return is commensurate with the risk.