The risk and return trade-off (tradeoff) is one of the tenets of life — not just finance, but of everyday life! It’s certainly one of the core principles of investments. But curiously, I’ve seen how it applies to virtually everything.
From basketball to running a marathon, singing, politics, and even mating, there are many (unusual) real-life applications to this investment principle.
I hope these real-world examples, and the finance examples listed below, help you get to know this fundamental principle a bit better. It’s crucial, I think, to anyone’s investing and financial freedom aspirations.
(Related: 9 Big Steps to Achieve Financial Freedom)
What is the risk-return tradeoff concept?
The risk and return tradeoff is basically the “high-risk high-return” mantra. The more risk you take, the higher the potential return. This is why, in business and finance, small actions typically lead to small results.
A few important points to keep in mind.
Not all risks are compensated
In finance, only systematic risk is compensated. You don’t have to worry about what that exactly means. Just know that some risks are pointless.
(Related: Diversification primer)
High return is merely potential
When you risk more, the possible returns you get aren’t guaranteed. Otherwise, it defeats the purpose — It’s not risking anything if returns are guaranteed.
If you put yourself out there and it pays off, it can either pay off big, or you can lose big time. On the other hand, if you play it safe, the rewards aren’t that great but you’re safe from embarrassment, financial loss, or even death.
Neither right nor wrong choice
The choice between a more vs less risky action isn’t about being right nor wrong. It’s about your preference. Some people are more risk-tolerant than others. And that’s not saying some are better than others. They’re just different.
Non-financial risk and return trade-off in real life (examples)
How can the risk and return trade-off be applied in real life? Let’s take a look at some non-financial (at least not directly) examples of the risk and return trade-off in real life.
(These are my top-of-mind examples. Share yours in the comments below.)
Running a marathon: Going too hard
When running a race like a marathon, racers are careful not to go out too hard because there’s a risk of blowing up mid-race. This is why runners practice pacing.
Do you go harder and potentially win, or do you err on the side of caution and go a little slower? Going a little bit harder is riskier, but the chance of winning (or at least beating your personal best) is also greater.
Singing: Belting high notes
We all have our normal vocal ranges. Belting and brushing near the limits can be praised, but failing can be very embarrassing.
Legal: Breaking the law
Do you go for the yellow traffic light? If you make it, you save time. If you don’t, that traffic enforcer’s going to make sure you don’t save time.
Or how about stealing? You could unfairly get ahead. But if you’re caught, the setback is a lot worse.
Politics: Having a voice
There are fewer domains that cause more mass polarization than politics. Should you express your opinions or not?
The vocal fanatics either get praised as heroes or vilified as criminals.
Academics: Controversial takes
Conforming to researches of past scholars is easier to do. But when you come out with a controversial take, the risk and returns are higher.
You’re either commended for your unique take, or ridiculed for your stupidity.
Basketball: Going for the steal
You can either stay in front of your man or go for the steal. When you go for the steal, and miss, it leaves your opponent wide open, or maybe a lane to the basket.
But when you do get the steal, that’s (hopefully) a fastbreak point for your team.
Lots of male insects die after mating (e.g., honey bees). I wouldn’t know what they’re thinking, but I guess to them it’s worth dying for.
But even in us humans this applies. Do you go for the girl or guy? (There are other examples but I’ll leave them to your imagination.)
Financial risk and return trade-off in real life (examples)
I hope by now it’s clear how the risk and return tradeoff applies in real life. Now by your familiarity with the concept, let’s take a look at a few examples in the world of finance.
These are a mix of the most common examples and some uncommon ones I noticed.
Emergency fund vs. no EF
Emergency funds are kept in safe asset classes such as deposits and money market instruments — in traditional or digital banks.
They inherently have low returns. If you choose to build an emergency fund, you protect yourself from, well, emergencies.
But it also means giving up on assets with higher returns. Do you allocate money to your emergency fund, or do you invest in higher-yielding assets?
Peso-cost average vs. lump-sum
Peso-cost averaging (PCA) keeps you in the middle. This point is probably too long to explain here (See: Peso-Cost Averaging Advanced Guide: Know if It Works for You), but the case is about PCA as a risk-mitigating strategy.
When you invest everything upfront (i.e., lump sum) and the market steadily goes up, then you take full advantage of compounding and earn more. But when you’re wrong and the market steadily goes down, the loss is larger.
Savings vs. investment
Investments have the potential to lose money while savings are mostly guaranteed. This is basically the EF vs. no EF point made earlier.
A related tradeoff is between well-established investments (e.g., stocks) vs. up-and-coming platforms (e.g., cryptocurrencies). Or long-term investing vs. day-trading.
Employee vs. entrepreneur
This is another one of those commonly mentioned examples. Employment provides income stability and safety whereas running a business doesn’t guarantee anything. But the income potential from a business is a lot higher.
Apartment vs. hotel
Based on our experiences, the initial costs to build an apartment and hotel are very similar. That’s not surprising. But your decision to proceed with operating either an apartment or a hotel has a huge impact.
Hotels are the riskier venture. They also potentially earn more. Mid-range hotels charge anywhere from Php500.00 ($10.00) to Php5,000.00 ($500.00) and beyond per night. That’s Php15,000.00 ($300.00) to Php150,000.00 ($3,000.00) in a month for a room that’s likely going to rent for a lot less as an apartment.
That said, apartment tenants usually commit long-term, and that provides stability in income to the landlord. Not to mention the lower costs to operate an apartment (e.g., less staff to manage the property).
(Related: (1) How to Value and Apartment Building: Expert Tips by a Pro for Beginners, (2) Apartment Deal Analyzer (Should You Buy), and (3) Building Wealth with Real Estate Through Property Accumulation)
Insurance vs. no-insurance
Also similar to the EF vs. no EF argument. Insurance costs money — money you could’ve invested. If you end up using your insurance though, then your premiums pay off.
Debt vs. no debt
Using debt can multiply your returns. But it also magnifies your losses. It’s leverage, like a wrench magnifying gains and losses.
This is kind of an advanced topic, and beginners probably shouldn’t use debt, but keep in mind that it’s a tool you may revisit when you’re comfortable with it. I’d go as far as saying it’s necessary if you want to accelerate financial freedom. And yes, the accelerated financial freedom (higher return) also comes with added risks.
This was never meant to be a comprehensive list of how the risk and return trade-off applies in real life. Far from it!
Instead, this was about the familiarization of a fundamental concept in finance. Knowing the concept is a step closer to smarter investing.
The importance of risk-return, the trade-off, cannot be understated in decision-making. There is a tradeoff in a lot of things, so question anything that seems too good to be true and rethink safe routes that don’t align with your goals.
And also know that this isn’t being about right nor wrong, but rather a matter of preference.
In what aspects have you noticed the risk-return tradeoff in YOUR life?