The Risk-Reward Dilemma In Finance

In finance, It's a common occurrence to face a situation where one has to choose between a risky and a safe option.

It's either a venture that offers potential high returns coupled with high risks, or a venture that offers low returns with equally low risks. It could be deciding whether to buy or rent a house, start or join a business, diversify or concentrate one's portfolio.

In this type of situations, the risk-reward dilemma is always present. This is the trade-off between the potential return and the associated risk of an investment or a decision.

Despite the many variables, everything comes down to two options and each is quite different from the other. It's never a wise option to take the decision lightly. It is very important and relevant actually, as it can affect our financial outcomes and well-being long into the future .

Interestingly, this dilemma is hardly influenced by objective factors, such as the expected value, the variance, or the probability of outcomes. It's mostly influenced by subjective factors, such as our psychological and behavioral characteristics.

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A Common Scenario

Retirement is something that most if not all people dream or work towards achieving. This is a common and important financial decision that people face about how much to save and invest for their future income and security.

Finding the right balance between spending now and saving for later is the challenge. While also coping with the market and economic fluctuations.

Natasha earns about $100,000 a year as a software engineer. She's 30 years old. Her goal is to retire at 65, with a yearly income of $80,000.

Suppose she has two options. The first is to save and invest $10,000 (10% of her income) every year in a low risks, low returns portfolio with 4% rate of return per year.

The other option is to save and invest 20% of her income every year in a portfolio with high risks, high returns of 8% per year.

Which option should she choose?
Choosing the first option will mean she'll have more money to spend on her present needs and wants. But on the flip side, her money will not be growing much over time since 4% rate of return isn't much after all.

When retirement comes, the investment fund will reach $1.2 million and allow her to withdraw around $48,000 a year based on 4% withdrawal rate. This is $32,000 short from her desired retirement income of $80,000.

Now, choosing the second option has some perks. Yes, she will have less money to spend at the present on her needs and wants. But over time, her investment will grow substantially at 8% per year.

When retirement finally comes, She will have accumulated $3.9 million on her investment fund. This translates into having the ability to withdraw $156,000 a year. With the second option, she will have a surplus of $76,000 per year from her desired retirement income.

But if we look closer, we’ll find a hidden drawback: the first option is much safer than the second one.

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Obviously, there is no guarantee that Natasha will earn 8% per year on her high risk investments. She could earn more or less depending on the performance of the financial markets.

Moreover, Natasha could also lose some or all of her investments due to market crashes, economic headwinds or a black swan event.

The first option is safer but also less rewarding; the second option is more rewarding but also more risky.

How should Natasha decide? If you were in her situation, how would you make a choice? What would affect your choice?

Psychological And Behavioural Factors

Because she's a software engineer, I can presume that Natasha has a good degree of rationality. This type of people often have a high risk tolerance. In this context, risk tolerance is the degree of uncertainty that one is willing to accept in their financial outcomes.

While many are either risk-averse or risk-seeking, some are seemingly risk-neutral like my uncle. Says that he's indifferent to risk and chooses an investment based on the expected value.

Risk tolerance can affect how much one saves and invests for their retirement, as well as the type and mix of assets that one chooses for their portfolio.

Just because Natasha presumably has a high risk tolerance doesn't mean she'll pick the second option. There are other factors at play apart from just risk tolerance.

One of the other factors that can influence Natasha's decision is her emotions. Emotions are subjective feelings that can affect how we perceive and react to different situations.

Perhaps, she is feeling excited or confident at when she's about to make the decision. In that case, she might be inclined to choose the second option since she'll perceive the potential reward as more attractive than the potential losses.

It's the opposite if she's feeling sad or doubtful. She'll be defensive and choose the safer option with less risk.

One could say the decision is made based on randomness and the dilemma is whether to go with the randomness or not.


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Posted Using LeoFinance Alpha