Risk Vs. Return - YouTube

So what is risk?

Let's start by understanding what is risk, we hear that

the word risk used in many different context in, I think most common

understanding of risk or our intuitive understanding of risk is about relating

to danger of loss, or possibility of loss which certainly it's one useful

definition of risk but for looking at the relationship between risk and return

and successful... in scaleable entrepreneurship, I want to use more

of a financial definition of risk which is that the volatility of returns. So I

think once we have a more specific understanding of what is risk for our

purpose we'll be able to understand better what is the relationship between

risk and return.

So with that understanding of what is risk we can look at... start looking at

what is the relationship between risk and return? I think most people would

have heard the expression 'high risk high return, low risk low return' and this

would be... this would summarize their understanding of what's the relationship

between risk and return. These two phrases sound like they mean something

very similar so high risk high return, low risk low return but do they really

mean something very similar or do they mean something very different I think we

can understand that better if we try to convert these two statements or

transform these two statements into if-then statement if-then statement is a

statement in the form of if something then something else so if something is

true then something else always follows though let's look at those two

statements about risk and return transformed into if-then statements

let's take the second one first if I take low risk then I will achieve low

return is this true or false? At first it sounds like this might be false we

because we believe we might be able to think of an example of a low risk high

return investment because if the statement of if there if I take low risk

I will receive low return as false this means there must be a low risk

investment that delivers other than low return and let's rule out the case of no

return and therefore if we want to say that the statement if I take low risk I

will achieve low return is false we should be able to come up with at least

one example of a low risk investment that delivers a medium or high return

and I'm pretty sure that if we... no matter how much time we spend on that we're not

going to come up with an example because I believe that there are no lower

high return investments there only low risk low return investments and high

risk high return investments and of course medium rare medium return

um now some of the exception cases that when I asked this question to large

groups people some of the exception cases that usually come up are well what

about lottery tickets aren't lottery tickets low risk high return investments

because I invest only a very small amount of money but if I win I can win a

large amount of money this is confusing the amount that is wrists with the level

of risk just because lottery tickets are inexpensive doesn't mean they're low

risk in fact lottery tickets are extremely high risk that for the buyer

they're so high risk that in effect the buyer is guaranteed to lose money on

every lottery ticket the expected value of the lottery ticket is negative. We

know that this is true because we can look at the other side of the lottery

game and see that lottery tickets are sold by government who is basically

guaranteed winner on every lottery ticket meaning they are guaranteed that

every time they run the lottery they're gonna make money which means that on the

other side all the lottery ticket buyers are guaranteed losers. The same logic

holds true in another example of low risk high return investment that often

people think of when I ask this question; what about in casinos so if I play a

game in a casino I can just bet a little money and win a lot of money you can see

it's exactly the same dynamic as lottery tickets casino games are structured in

such a way that players will be net losers and the casino will be net

winners this is why casinos earn million a million or millions of dollars a day

in gamblers lose so much money in casinos. You might think but wait wait a

minute in my two examples is in government making a low risk high return

investment because they get to sell lottery tickets it's true governments

can create low risk high return investments for themselves because their

governments but low risk high return investments are not accessible to

ordinary investors in in ordinary investment markets and same thing with

casinos although they do experience... they do get to play the other side of the

casino game in which case the the odds are in their favor but they are also

subject as businesses to all the other risks of operating a casino or casinos

Resort in the hotel industry and subject to competition by other casino resorts

and also overall economic condition so we can see that none of the examples

that we come up with are going to give us low risk high return investments with

one exception one of my one of my examples of possible low risk high

return investment is in high-frequency trading

we're certain arbitrage strategies can generate what appear to be risk-free

investment, a risk-free returns or a very low risk return but a very low risk high

return for hedge funds or others that are using those strategies however when

we look closely at that example so high risk this high frequency trading returns

we can see that they persist, the opportunities that generate these

returns only persist for extremely short periods of time this illustrates the

reality of low risk high return investments if they ever do appear they

disappear almost immediately. How can we understand that concept a little better?

I would ask how many people have ever found $100 bill in the street? The answer

is very few people have ever found hundred dollar bill in the street I

asked this question to thousands of people and there's only a tiny handful

that I've ever found $100 bills how many people find small coins in the street

everybody finds small coins in the street. Why? What's the difference between

finding small coins in the street and finding hundred-dollar bills in the

street? When we find small coins in the street this is a low risk low return

opportunity if we ever find hundred-dollar bills in the street,

it's a low risk high return opportunity which is why it doesn't happen and why

doesn't it happen? Because when hundred dollar bills appear in the street very

infrequently, somebody else always finds them first not you, that's how these... that

illustrates how these low risk high return opportunities if they do appear

are erased almost immediately by market forces

Imagine that there's a company that we can measure the risk level, we can't

really do it like this but imagine we could measure the risk level of that

company as risk level five all other companies in this market of risk level

five are paying return five which is exactly commensurate with the risk.

Now, imagine that our company starts paying return level six why are they

doing that? Now they're paying a higher return than they need to given the risk

in that investment. They're doing this because they have a short-term need for

cash when they get enough cash to satisfy that short-term need they will

reduce their return this shows that the the high degree of positive correlation

between risk and return is driven by the supply and demand for capital, so when

there's a mismatch between supply and demand for capital the market

will correct this relatively... in most cases very quickly so that the return on

any investment will always reach an equilibrium level with the risk that the

market perceives in that investment. So what have... what conclusions can we draw

from this? If we want to generate high returns we have to take more risk, if we

are not willing to take more risk we must be satisfied with the level of

return commensurate with that risk this has extremely important

implications for scalable entrepreneurs, why? Investors who invest in scalable

companies, meaning venture investors, are looking for high risk investments, why

are they looking for high risk investments? Because they're investing in

these startup companies to increase their returns

therefore scalable entrepreneurs should be prepared to take a much higher level

of risk than typical... than the average person in the population and even

typical entrepreneurs. So example to make it even more clear, if I'm a

venture capital investor and I'm listening to a pitch by a startup who

tells me I have, you know, a great business idea it's not risky at all, it's a sure

thing, this is now... if I believe this entrepreneur this is now not an

interesting investment, why? If it's a sure thing and there's no risk at all

then the return in this investment will not be high enough to exceed the hurdle

rate in my investment making decision and therefore not interested.