Maximizing Risk and Reward
When I was 16, a week before Junior year homecoming, my mom presented me the biggest choice of my life: what car do I want to roll up in at Bixby High. Somehow the search resulted in choice between a 1998 Jeep Cherokee or a blue 2004 Honda Civic Hybrid. My mom tried to nudge to get the civic, but she could not win the battle against my heart eyes for a cool looking Jeep. My Jeep, in all her glory, had a shot alternator, a horrible smoke smell, and like 15 other traumatic issues I blacked from my memory. Despite all those flaws, the one I find funniest today was the fuel efficiency. My Jeep had 15MPG, and at some point, a sensor errored and for a month it had a scorching 8MPG. The Honda on the other hand, 48MPG. Yes, 48MPG! Even driving a newer and more efficient truck today, 48MPG is hysterically, absurdly, better.
Reflecting years on later my 16-year-old boy decision, I find that no matter where we look there are always trade-offs. I traded headaches, and fuel economy for the look and feel of the Jeep Cherokee. Still, to this day, I do not regret buying the Jeep. I cannot describe to you my irrational fulfillment. Yet, the principle looking forward is that we try to always get more with less, but the reality is there are trade-offs in all activities, commitments, and purchases. Within those activities, we try to eliminate the downside and maximize the upside. I badly desired the Jeep, and I sacrificed 40MPG for it. Almost nothing in this life is exempt from this principle: the choices we make have trade-offs.
Examples of Trade-Offs
1. Reading: Read (and comprehend) as many pages in as little time possible.
2. Eating: Eat as much food and still look beach ready (I am still trying to look beach ready).
3. Business: Charge the highest price and keep customers. Economic equilibrium
4. Boxing: The sweet science. Hit and do not get hit.
5. Thermostat: Having the coldest house in summer, and the lowest electricity bill. Dad Science
These relationships are swirling all around us. It cannot even escape your own thermostat. So, what am I getting at? Of the above things, they work inversely to each other. If the temperature goes down, the electricity bill goes up. But is it as efficient as possible? That is the question. Can we squish the relationship to the maximize efficiency? When it comes to investing, we take the same approach. In investing the trade-off is Risk vs. Reward.
The process to investing begins with the end – the goal. You can either pick risk or reward first and the exercise works the same.
Start with reward:
1. What sort of return does your plan require to be successful?
2. Target that return with as little risk as possible.
Start with risk:
1. What sort of risk are you comfortable with taking?
2. Target that risk with as much return as possible.
That is the squish process. In investing there are several ways to achieve maximum squish. There are many different aspects to achieving that, like diversifying in international and small companies, and tax-management techniques. These are just a few, but all help in squishing the reward upward while pushing the risk downward.
For those who need to see it visually, here is my graphical representation of this relationship. Note this graph applies to investments and every other trade-off scenario.
In this graph, the X-axis is the pain (the electricity bill), and the Y-Axis is the reward (cold AC). The best place to be on the graph is on the top left – the most reward with the least risk. And the worst is the bottom right – the most pain with little to no return. We know that the two are tied, so we cannot eliminate one without the other, so the curve is the best efficiency you can get for each unit of risk or reward. Note, that as we desire more reward the amount of risk we take must increase. And at the very end of the spectrum, if we want even just a blip more return, we may have to take on a heap of risk. So, if your financial plan, or goal in an activity does not require the highest amount of return than it may be more sensible to give up a little upside. So being aware of your goals and your relationship to risk and reward is crucial in succeeding. For example, a boxing enthusiast may want to take their sparring skills to the next level, but that may significantly risk their health. The tradeoff simply is not worth it. Yet, it takes a certain amount of self-awareness to make this decision. We must figure out what reward we want to achieve, or risk we are willing to accept and then squish it to its most efficient point.
If you like this representation of risk and reward and think it is straightforward, thank Harry Markowitz, a finance professor and winner of the 1990 Nobel Prize in Economics. None of the above ideas are really my own. The above graph is often called the Markowitz line, and has shaped modern portfolio theory. The link to the original paper can be found here:
I personally believe the Markowitz line extends to many different aspects in life other than just portfolio theory. See what things in your life the Markowitz line applies to and let us know. The application of this idea boils down to again, your goals and plans, and your self-awareness on those ideas in life. When I was 16, I certainly was on the far-right flat side of the curve. I traded a safe, reliable car, with a massive disparity in gas mileage, and took on a lot of risk. But I was also the coolest kid in Bixby High School, or at least that is how it felt. And I would not trade that away.