Revised and updated
From the Wall Street Law Blog: Caution, common sense ahead-
These days, we hear too many people mistakenly describe the risk-reward tradeoff with incomplete, shorthand definitions like "risk equals reward," or "the greater the risk, the greater the reward."
Investors should use the following definition for market risk:
Market risk is the chance that an investment in securities might produce an unexpected bad outcome; a/k/a financial loss.
This definition for risk applies equally to the actual fact of losing money on any investment - an outcome that is always unexpected to some greater or lessor extent - and also to investments that produce higher magnitude losses than the investor expected.
To digress for a moment: An expected bad outcome is not really a risk because a company will build expected losses into its business model. For example, suppose a bank assumes that the default-rate on a credit portfolio will be 2 percent. Because the losses are expected, the bank should build a 2 percent loss into its revenue forecasting as a cost of doing business.
Thus, while some investors are enticed to put their money in risky ventures because there is the potential for greater upside for a risky investment than there is for a conservative (safe) investment, the higher upside is far from free.
Thus, the more risk you take, the more you increase the chance of an unexpected bad outcome.
Which brings us to this pearl of wisdom: When it comes to risk, it pays to remember the warnings of the great Jimmy Cliff (and the late great Jerry Garcia): The harder the come, the harder they fall, one and all...
By Brett Sherman