Planning

Risk vs. Reward: The Ultimate Calculation

Who can hope to be safe? who sufficiently cautious? Guard himself as he may, every moment’s an ambush.

~ Horace

You’re at a fork in the road. Which way do you go? We face decisions every moment of the day. Some are more important than others. Should I invest in stocks? How much of my money should I invest? Where will interest rates be this time next year? Where will they be in 5, 10, or 20 years? Should I buy or sell? Should I allow my child to do X? Should I stay or should I go? (Cue The Clash tune.)

Unless you are clairvoyant, there’s no way to know for sure whether your decision will be the right one. In the end, we all have to do the best we can with the information we have at the time. The decision you make may not be the decision I would make, but it will be yours and it’s probably the right one for you.

There is one decision-making tool that I’ve learned to use over the years that helps me organize my thoughts. I learned it from traders. It’s the risk-reward calculation. In other areas of business, it might also be called a cost-benefit analysis. In layman’s terms, it basically involves a list of pros and cons.

5 Essential Questions to Ask Before Any Important Decision

Here are 5 basic questions you can ask yourself before you make a decision. The first order of business is to simply stop and take the time to go through this exercise.

1. What Are the Potential Rewards?

What could you gain by performing action X? It could be a dollar amount, or something less tangible like peace of mind or the respect of your teenager or co-workers.

2. What Value Do You Place on the Potential Rewards?

This question, in some respects, is more important than the first. If you don’t personally value the rewards presented by action X, what’s the point? If you are a numbers person, you could even place a numerical weight on each reward factor and come up with a mathematical model for whether or not you should change jobs, buy a home, etc.. For most of us, this is over the top. But if it makes you feel better, open up a spreadsheet program and get busy. And hey – consider sharing with those less numerically endowed!

3. What Are the Potential Risks?

What risks are inherent in action X?  What could go wrong? What is the likelihood that the risks you’ve outlined could materialize? How much money could you lose? You could allow your child to do X, and they might get hurt. Again, the mathematicians out there could get out of control here with probability calculations, but you don’t have to get that detailed – unless you want to! 😉

4. What Value Do You Place on the Potential Risks?

If you could potentially lose $500 on an investment, you might be fine with that. But if that $500 represents 50% of your capital, you might see things differently. If you’ve just lost your job, you might not want to risk any of your capital. If your child might get hurt while doing action X, but the risk is mild physical or emotional injury rather than major bodily harm or long-term psychological damage, you may feel more comfortable saying yes.

5. What If You’re Wrong?

My son hates math. He has referred to variables and unknowns in very colourful terms on occasion. Indeed, variables and unknowns can really throw a wrench into your tidy risk-reward calculator. What if the rewards you anticipate don’t materialize?

What if there are risks out there for which you have not accounted? By definition, you cannot enter the proverbial Black Swan into your calculations. For those who aren’t familiar with the term, I’m referring to Nassim Taleb’s bestselling book about the highly improbable. (Tangential Mini-Rant: Many have said that the recent (ongoing?) financial crisis was a black swan event. I disagree.)

The key here is to outline some contingency plans. How will you react if your investment does lose $500? Will you sell it, or hang on in hopes of a recovery? How will you react if that recovery never happens? How will you react if you are correct and your investment appreciates by 20%? Will you take your money off the table or double down? You need to have a plan in place before these things happen.

These guidelines won’t guarantee a winning decision. Nothing can do that. But at least you’ll know that you’ve given your choice some serious thought and arrived at the best decision you could under the circumstances.

What do you do when faced with a tough decision or a true dilemma? What has worked for you?

Comments

  1. Doctor Stock

    I find people cannot accurately measure risk until they’ve experienced the consequences of that exposed risk. The know your client questions often lead to optimistic answers until they markets crash… then people FEEL the risk and they’re uncomfortable. Just a thought…

    • 2 Cents

      I think you’re 100% right on that one Doc. I’m sort of hoping people will use the recent market crash as a gauge of their risk tolerance and make the necessary adjustments.

  2. Doctor Stock

    Wouldn’t that be nice… It’s unfortunate that people have to lose something before they recognize its true value and how difficult it is to replace. I imagine that theme resinates with much of what you believe and do on this site!

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