Risk and Return ...... not necessarily antitheses!

For capital investment choice, is there any useful correlation between risk and return?  Do high-return projects imply high risk and visa versa? 

 

In a word—No!  But you won’t see much support for this idea in many economics texts.

 

One problem is the definition of risk.

 

For most of us, risk is the scope to make a wrong decision, and the exposure to injury or loss associated with the resulting outcome.  This is quite different to the definition in most economic theory which equates risk to an outcome “capable of actuarial treatment”— some statistical distribution of outcomes. 

 

An outcome that leaves us better off by some amount in the range $1 million to $2 million (a uniform distribution, say) is still a risk under most economic definitions, but involves no exposure to the chance of injury or loss.

 

“Risk” in most economic theory does not require knowledge of what the alternative choice might be.  Real risk does require knowledge of the alternative. 

 

Let’s say that one of your choices is subject to uncertainty—outcomes might be anywhere in the range $1 million to $2 million.  Assume further that your best estimate—the expected value—of this choice is $1.5 million.  Now let’s say an alternative choice is a guaranteed $1.25 million.  Now there is risk attached to the decision.  Choosing the first alternative also means a 25 percent chance of loss compared to the other alternative.

 

This situation applies to any risky choice.  World War I soldiers who raced out of their foxholes into a barrage of enemy fire had a high chance of an unsatisfactory outcome, but if their next best alternative was certain death in the trenches then they weren’t taking a risk at all!

 

What does this mean for large new capital investments compared to, say, investments in the stock and bond markets?  On the stock market you can overlook other alternatives, because you can rely on other market participants arbitraging choices into a neat risk-return spectrum.  Non-market investments enjoy no such assistance.  High return investments can be low risk—particularly if you know something that other market participants don’t know, or if you have proprietary inputs unmatched by anyone else.

 

But notice the important requirement here for rational choice.... you do need a “big picture” view.  In addition to understanding the project in front of you, you must also have knowledge of what else you might do, and you must privately understand the uncertainty characteristics of all alternatives.

 

Too much of our corporate world has lost this big picture view.  You don’t necessarily need to take high risks to get high returns.  But you do need lots of alertness to the alternatives because you can only rely on yourself, not some “market” consensus to understand these risks.

 

The risk-return trade-off is very extensively covered in my book Capital and Uncertainty which also sets out quantitative mechanisms for comparing alternatives with different risk/return profiles.