The Real Meaning of Risk

By Curmudgeon – Curmudgeon’s a long-time friend of brip blap and I always appreciate his contributions; here’s his latest:

free


I’m afraid that I mentally hit the ceiling earlier when I read a comment on one of Steve’s posts.
The comment was:

In real estate, the quicker you can go into massive debt, the quicker you can become massively wealthy. (Link)

It’s true, but in a very misleading way. The operative word here is “can.”  It is easy to miss, and many people will automatically interpret this as “will” or even worse, “probably will.”  That is precisely incorrect.

If you go massively into debt, what you do is you take on a massive amount of risk.  Risk isn’t necessarily a bad thing; we take risks many times every day – getting on the highway, crossing the street, eating that Big Mac (well, a bunch of Big Macs, over time).

But in general, the odds of us succeeding in getting on the highway without an accident are pretty good. Most of the day-to-day decisions we make regarding risk turn out just fine, because our chances of being successful are pretty good.

Going massively into debt, with the expectation of making a massive amount of money? Well, the odds there are not so good.  It’s not strictly a crapshoot, because it depends on your timing.  If you get in early, it has a better chance of paying off.  If you get in later, your chances decrease significantly.  Guess what?  The timing part is the crapshoot.  There is no timing the bubble.

If you take on more risk, you have a chance of making more money. But that chance is smaller.  In fact, sometimes it’s downright nonexistent.  How can you tell when it’s tiny or nonexistent?  Well, you can’t.  You have to assess it with incomplete information and no clear vision of the future, and that’s not the easiest thing in the world.  But if you are taking a lot of risk, you need to understand that a big return, or even any return, is by no means a sure thing.

That doesn’t mean that you shouldn’t consider leverage in your investments. Risk isn’t a bad thing.  But you have to understand your tolerance for risk, and to understand how much risk you are taking.  These are inexact concepts, and people assess them imperfectly.  We make mistakes.  If you bet the house, you may lose thehouse.

So yes, you can do real estate, or even any variety of other investments, and go massively into debt.  But you might prefer to buy a lottery ticket instead.  You’ll lose less, but you may be able to sleep at night.

photo credit: jonrawlinson

10 comments

  • GoForexYourself

    You must take a risk to receive and award. The problem is when people take on a huge risk to receive a large reward to get rich quickly and it doesn't turn that way. I personally like to keep my risk/reward ratio on a 1:1 scale.

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  • I prefer to take on huge risks only if I'm playing with the house money. If the only possible outcomes are wealth or bankruptcy, I'm sitting it out. If that classifies me as risk-averse, so be it.

  • What do you define risk as?

    What you are putting? Or the likilhoood of loss?

  • Chad @ Sentient Money

    Not that you said it directly, but I agree the majority of people are not good at determining risk. However, I don't agree with:

    “But you have to understand your tolerance for risk…”

    I'm not disagreeing with the need to understand our tolerance, but with the idea that understanding our tolerance is very important. The idea of defining our tolerance has been preached ad nauseam, but it's useless because no one has any idea how to actually judge risk. A good example is flying vs. driving. Every bit of evidence proves that flying is safer, but large numbers of people are still scared to fly.

    The risk tolerance thing is just another way for people selling financial products to ease people's fears without actually providing any real value.

    Sorry, I know this was barely anything in your post, but it jumped out at me.

  • I disagree with your statement “If you go massively into debt, what you do is you take on a massive amount of risk.”

    I can take a $100K loan on a house that has a market value of $200K. The risk there is relatively low; there's an excellent chance that I'll be able to sell the property, or otherwise profit from it, sufficiently to cover my $100K debt.

    The amount of debt is in no way correlated to the degree of risk.

    • Um, unless the house either has a serious problem, or is likely to fall substantially in value. If you are getting it that far under “market value,” you either have a substantial inside track or, I'm sorry, you are the fool in the market. Markets aren't always efficient, and occasionally they can pay off for you, but to bet on it is always a risk.

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  • Um, unless the house either has a serious problem, or is likely to fall substantially in value. If you are getting it that far under “market value,” you either have a substantial inside track or, I'm sorry, you are the fool in the market. Markets aren't always efficient, and occasionally they can pay off for you, but to bet on it is always a risk.

  • great post. thanks