Doing Away With the Risk-Reward Curve

in Risk

The risk-reward curve is a useful thing to follow if you want to remain middle class. If you don't know what the risk-reward curve is, it is this theory: the more risk you incur, the greater your rewards can be; the less risk you incur, the smaller your rewards will be.

It doesn't sound like there's much you can do from this. It's really just gambling, but you get to pick your odds. How, then, could you ever acquire enormous amounts of wealth? Do you just pick the riskiest (but highest reward potential) investments and get lucky? Surely nobody in the world has that much luck that they win time and time again and become billionaires. That is because the risk-reward curve is just a tool for the masses - it is sophisticated gambling.

If you want to really be rich, long term, then you need to move beyond the realm of the risk-reward curve. You need to realize that it is really possible to acquire huge amounts of reward with little risk. Although many financial planners would argue with this point, the simple fact is that it is true. The richest people in the world didn't get rich by getting lucky again and again. The richest people in the world know how to minimize their risks and maximize their rewards. If you start believing that this is possible, then opportunities will start appearing before your eyes.

In Security Analysis, Benjamin Graham gives an example where a person borrowed money to buy General Electric bonds on margin at 2% interest - these bonds were set to mature the next quarter at 6% interest. A unique situation dropped the price of these bonds to a level sufficient to make a profit. The investor made 10% off his money in one quarter, which is the equivalent of 40% per year. A high profit was made with little risk. The likelihood of General Electric defaulting on its bonds was very slim. Situations like this are not uncommon among savvy investors.

What does it take to make a high profit, safe investment? Work - lots of work. You must become educated. Warren Buffett, when asked about finding good companies to invest with, replied with "you have to overturn hundreds of rocks to find the anomalies." You may spend months pouring through financial statements without seeing a single worthy investment. You may have to spend years studying before you are capable.

Regardless, if you want to be rich, long term, then you need to move past the risk-reward curve and put in the effort needed to make safe, highly profitable investments.

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Cody Scholberg has 1 articles online

Cody Scholberg

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Doing Away With the Risk-Reward Curve

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This article was published on 2010/04/01