Risk and Reward or Return

If we want to play the game of life we must be prepared to take risk. But risk-taking in itself is not the name of the game.

A person with rational attitudes toward risk must recognize that risk should be evaluated within the context of an expected gain or reward (or return). That is, the point is not to take risk for the sake of risk, but rather to take risk with a view to achieving some desired outcome. Taking a high risk for a low return is not as attractive (or sensible) as taking a low risk for a high return.

The traditional process of risk mitigation often ignores the potential returns on various risks. In practice, decisions cannot be made without taking into account both risk and return.

Decision making Using Risk & Return:

1. Estimate the risk
2. Estimate the expected return
3. Examine whether the risk can be reduced and quantify the cost of doing so
4. Calculate the net expected return (expected return minus the cost of risk reduction)
5. Calculate the net risk (initial risk minus risk reduction amount)
6. Compare the net expected return to the net risk
7. Select the alternative or action that yields the most favorable ratio of net expected return to net risk and is within your risk aversion and risk tolerance comfort zones

The word ‘favorable,’ above, refers to a net expected return that includes an acceptable risk premium for the net risk taken.