On today’s show we’re talking about the link between risk and reward. The conversation started over a lunchtime discussion in Dallas.
We’ve all heard the phrase “high risk, high reward”. The opposite side of that coin is low risk low reward.
On today’s show I’m here to tell you that there is no real link between risk and reward. The phrase which has been repeated so many times is utterly false and yet people repeat it like a law of nature.
Risk is risk, and reward is reward.
It starts with the notion of what is a risk.
A risk is anything that is not in your plan. The fact is, that risks can have significant impact, even if their likelihood of occurring is low. If that item is taken into account, and embedded in the plan, then by definition it is not a risk.
If the risks are already visible and the impacts can be quantified, then you can start to attach a risk premium to a plan or a project.
For example, if you have a loan that is secured by a mortgage in first lien position followed by a loan that is secured in second lien position, most would agree that the second lien carries a higher risk of default than the first lien. For that reason, the second lien position lender attaches a risk premium and charges a higher interest rate in exchange for accepting that higher risk. It follows that a borrower with a poor credit score should be charged a higher interest rate than someone with a stellar credit score. The higher interest rate is a risk premium.
The phrase high risk, high reward has its roots in that notion.
But you can’t make the inverse general argument. Nothing says that all loans in first lien position are lower risk than all loans in second lien position.
Host: Victor Menasce