The Risk Reward Conundrum

I was on a CEO Zoom forum the other day talking about the Risk Reward Conundrum.   It had an impact on one of the participants who, as a result of the forum,  decided to adopt the “risky strategy” they had been putting off

What is this Conundrum?  This is the riddle that you can expect a better return on investment for risky investments compared to less risky ones.  There is a reward for taking risk.  See the diagram below.

Yet most of us are biased towards not taking risk – this is a psychological phenomenon known as “loss aversion”, which was articulated by Nobel Prize winning researchers Kahneman and Tversky in what they called “Prospect Theory”.  Essentially they showed that for most of us, our approach to risky decisions is not symmetrical – we are more concerned about the possibility of losing than we are excited about the possibility of winning. 

We see this in sport. It’s one of the reasons why tennis players like me, and Roger Federer, don’t come to the net as often as we should, given that our analysis shows there is a greater likelihood of winning if we do.  It’s the reason why football teams tend to set themselves up to favour defending over attacking, even though there are 3 points to be gained for a win, compared to only 1 for a draw.  Its why athletes who have experienced the pain of just missing out on medals are more motivated by that than by the joy of winning medals.

The interesting thing is how this psychological querk plays out when it comes to financial investment.  Why is there a reward for more risky investments – a higher expected return – a risk premium?   Is it because the risk somehow turns into an expected cost which offsets the expected higher return?  In pure mathematical terms, the answer is no.  Because investment analysts view risk generally as symmetrical – the potential upside is equivalent to the potential downside.

Is what really happens that the “loss aversion” of most investors means there is a disproportionately higher demand for low risk investments than there is for high risk ones.   The economics of this means that the higher demand for low risk investment leads to higher prices.  If the price of the investment goes up, the expected return on investment goes down.   And this turns into a reward – a higher expected return,  for the more risky investments.

In contrast to most business books on risk, my book “Risky Strategy” develops the case for the risky strategy, drawing on this kind of thinking.

You can also see and hear my online talk on this at: