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The Risk Premium

 

The first thing we learn in our financial education is that in order to make money, we have to take risk. Otherwise, there would be risk-free returns and those are notoriously hard to find. So, making money means having to take a chance that something may go wrong. The million dollar question is, of course, which risks do I take? Enter the prediction game and a whole industry has sprung up to answer these very queries. Financial services makes up more than 20% of the total value of the world’s stock markets. Yes, even after everything nearly imploded 10 years ago, and some (Deutsche) banking charts looking like a complete disaster.

 

But this post isn’t about banking or the merits of looking for clairvoyance. Rather, it is an attempt in trying to explain why we are making money. For the most part, people are afraid of taking risk, because there is an uncertain outcome. The thought of losing a lot of money can have a very detrimental mental and physical effect on the one taking the risk. In essence, that is why it works. An elaborate game of people willing to do different things at different prices, creates the perfect marketplace of supply and demand. The fact that someone isn’t willing to do something, simply means that someone that does, needs to get paid for the effort (and risk) they put in.

 

In today’s efficient world of investing, we can put a price on just about anything and we move a seemingly infinite amount of capital from one risk to the other in an instant. So, what is it then that we should do to stay ahead this elaborate game? There are really only two ways to mess up a good thing: betting all your money on one thing or overpaying for the risks we take on. If you think you have discovered the trade of the century and you need to act fast and sell everything you have so that you don’t miss out, then you have already lost.

 

A sucker is born every minute, but making sure that you know the market for the price you pay is the most basic of tools. If you know you can buy the same goods at a cheaper price without any additional effort (or cost), you would only ever choose one over the other. The same applies to the investment products you choose. It really is amazingly simple with the costs and fees of everything clearly displayed and explained according to financial regulation. And if it is still not clear, think of it this way: We know we can’t predict the future, but we also know that we get rewarded for taking risk, so why not just take different risks and stop paying someone to do impossible things.

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