Risk/Reward NOT Linked

At least they are not automatically linked.

Here is a description of the “Law of Risk and Reward” from somewhere on the web. . .

The risk versus reward curve is a fundamental principle in business. The simple explanation is that, as risk in a given transaction increases so does the reward.

This is the fallacy that most of us have heard many, many times.  We hear it so often, it actually seems to be true. 

But it definitely is not now, nor was it ever true that increasing risk increases reward.  

Alfred Marshal is the originator of the supply and demand curves that we were all taught in microeconomics. 

“in all undertakings in which there are risks of great losses, there must also be hopes of great gains.”
Alfred Marshall 1890 Principles of Economics

Somehow, as his idea above about “hopes” for gains was repeated over the years, the word “hopes” was left off. 

And in fact, it takes much more than “hopes” to get great gains out of great risks.  In fact, there are two paths to great gains…

  • Great Luck
  • Great Risk Management

The “Law of Risk and Reward” above seems to follow a fairness sort of reasoning.  It would only be fair if increased risk resulted in increased reward.  But the world is not fair. 

It is quite possible to:

  1. Get a large gain after taking a small risk
  2. Get a large loss after taking a small risk
  3. Get a small gain after taking a large risk
  4. Get a small gain after taking a small risk
  5. Get a large gain after taking a large risk
  6. Get a large loss after taking a large risk

There are several reasons for this.  First of all, the size of the risk is always an estimate made in advance with incomplete information.  Clearly the situations like number 2 above are cases where the risk may have been underestimated.  Also, the economists will emphasize that situations like 1 do not usually last for long.  (See the old joke about the economist and the $20 bill.)  A second reason is that the risk management performed by the risk taker can be effective both in terms of risk selection and in terms of loss severity mitigation.  However, the risk management tasks that result in good risk selection and effective loss severity mitigation require skill and execution. 

Risk takers who believe in the “Law of Risk and Reward” will tend to think that the time, effort and expense of doing good risk management is wasted effort since more risk results in more reward by law.

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Explore posts in the same categories: Enterprise Risk Management, Profits, Risk Treatment

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