Posts Tagged ‘reward

29
Mar
12

Risk & Reward

We all know the age old rule that the more risk we take, the higher the potential reward.  And we tend to think this relationship looks something like this:

We tend to think the relationship between risk and reward is linear.   In other words, for an additional amount of risk we take, we are compensated a proportional amount of reward, with no limit on the amount of reward we can reap.  This is common thinking when describing the Risk/Reward balance.

If we were whipping up charts to model our ideal Risk/Reward relationship, this is what we would want.

This way, we are compensated exponentially over the long term for taking more risk.  And, just as with the linear chart, there is no limit to the amount of reward one can reap.  Sadly, neither of these are the case when it comes to the stock market.

We are more likely to see diminishing returns for incremental risk that we take on.  Something like this:

Eventually we run into an asymptotic behavior, when we go out to infinity with our risk, the reward will seize rewarding for that additional risk.

So, when people say, “more risk = more reward,” stop a moment and think how you are being rewarded.  Is it in proportion to the amount of risk you are willing to take?  Will you be exponentially rewarded for your risks?  Will you take additional risk that barely return you more reward?

Food for thought.  What’s your risk/reward relationship?

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