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risk reward myth

Risk Reward Myth in Investing

I hope today I can help bust one of the myths that hold new investors and wealth creators in bondage.

Some time ago we wanted to re-capitalize one of our businesses and so we decided to mortgage our house to unlock funds. To my surprise the bank insisted that we use our residential home which was in our personal names as collateral. They refused other properties which were in company names. They know you will most unlikely allow your family home to be repossessed. They also insisted that we give them unlimited personal guarantees. They obviously wanted maximum assurance that we would pay back the funds borrowed. They were protecting their principal. They were protecting their down side or ensuring that risk is minimal.

When we did the maths we realized that when you take a mortgage you generally pay close to 80-100% in interests on the property if you have a 15-20 year fixed rate mortgage. They also charge lots of bank charges that increase their return. They consider the money lent to you as an asset because it generates them income. So banks lent you money on a high return with very minimal risk.

They do not seem to believe the commonly held “truth” that for one to get high rewards in investments one needs to take a high risk. We now take this position as an inviolable law of investing. We tout it all the time that the higher the reward the higher the risk.

However I have recently discovered that this is not what bankers and high networth investors do. In fact they pursue high rewards with minimal risks. They call it an assymmetrical risk reward which simply means they take the smallest risk possible for the largest return possible.

The concept of an assymetrical risk reward means that when you invest you ensure that your principal amount is protected so that if the market does not perform you do not lose the capital, but when the market performs you gain the maximum returns. So you have a minimal downside but a strong upside potential.

This is why Warren Buffet’s cardinal laws of investing are: 1. Never lose money. 2. See Rule 1. So he structures his investments in such a way to protect the principal and never lose money. Tony Robbins studied some significant billionaires and to a man/woman they all spoke about the absolute need not to lose money by exploiting structures that have assymetrical risk reward. And yet conventional wisdom has us take risks which are unprotected because of the myth of the higher the risk the higher the reward.

Surely this is another aspect of the information asymmetry that separates wealth creators and wealth losers. My buying into the commonly held belief of risk reward symmetry has caused me to lose money and destroy wealth in the past. Never again! I have just decided to learn from the money masters and model after them. I have just determined to study this more and am beginning to see some potential investment structures that provide maximum return with minimal risk.

I am wondering what would happen if we sought to invest in projects and investment vehicles that have low risk and high rewards. These may be difficult to locate but they do exist.

For example when banks give you a mortgage they also insist on an insurance cover over the loan. What kind of insurance can you set up when you take a risk? What protection system can you institute to reduce your exposure when you invest? What strategies are you going to put in place to protect your principal and increase the potential pay off of your investment?

In an entrepreneurial setting bootstrapping can reduce risk by minimizing your capital while increasing your potential reward. If you started your business by earning through consulting and using that to raise the funds – you can minimise risk. Starting a business with a huge cash injection whether as a loan or as own equity is risky business.

I trust that this posting will challenge your thinking so that you start thinking as bankers do and NOT as they say!

God bless.