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Does More Risk Really Mean More Reward?

One of the most common things I hear from financial planners is, “If you want to increase your returns, you have to increase the risk.” This is part of the stock and bond mutual fund philosophy of investing promoted by most financial planners. They say that if you want higher returns, you have to invest in stock mutual funds. And those are risky because the stock market goes up and down. That’s probably true for people who own mutual funds today.

I don’t know if this risk vs. reward idea is really correct. Consider someone driving a car. Saying higher returns requires more risk is like saying driving faster is riskier. Yes, driving faster is riskier, but only if nothing else changes. What if the skill of the driver improves? Which of the following would you say is riskier? An experienced race car driver, driving 90 miles an hour or a beginner driver driving at 50 miles per hour?

I think that more risk is required to get higher returns only if the skill of the investor is constant. If one investor has more skills than the other, then they may be able to invest with less risk and higher returns than someone who has less skills. It’s the same story as an expert race car driver compared to a new driver with a learner’s permit.

Investing in stock and bond mutual funds require zero skill. You simply choose one, fill out the paperwork or make the phone call, and then hope for the best. That’s one of the reasons that they are so highly recommended and are the most common investment vehicle in America. Now, instead of increasing our risk to get higher returns, what if it were possible to increase our skills instead?

How do you measure risk?
One of the challenges of investing is that people have no idea how to measure risk. How do you measure the risk involved in buying one mutual fund compared to another? What about comparing stock trading to buying real estate? How do you measure the risks involved in each? Most investors really don’t know how to measure risk, and are often unaware that they don’t know! The clients of financial planners, who know even less, are even worse at measuring risk. That’s one of the reasons that millions of people have seen their retirement portfolio drop by 50% in the last six months.

The point of this whole discussion is that it may be possible to reduce our risk by increasing our skills. What if a computer could drive a car? Is it possible that a computer could get so good at driving a car that it would be better and safer than a human driver? Many people say the answer is no. But there’s one small problem. The autopilot computer in a 747 is so good that it can not only fly the plane, it can even land it!

What if a computer could be programmed to invest in the stock market? Could it effectively measure the risk? Could it have the skills to invest with less risk just like computer that can drive a car?

This is the second post in a series entitled Secrets the Financial Industry doesn’t Want you to Know.

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