RISK is a four letter word!

A peculiar phenomenon among the human species is our comfort level with taking on risk.Some people relish the idea of being highly compensated for taking on a risky venture or investment while many other people try to avoid risk like the plague.The truth of the matter is, risk is very subjective.What may be seen as extremely risky to one person could be a walk in the park for another.

Much has been written about folks’ risk tolerance as it pertains to investing in the financial press.In fact, one of my favorite quotes from one pundit is “people have an unlimited risk tolerance when the stock market is going up and zero risk tolerance when it goes down!”That is so true!

One fact I believe almost everyone should agree on is that a person should be compensated for taking on additional risk.When it comes to financial returns, we were taught in Finance 101 that a “risk-free” return was generally equal to the yields paid at varying maturities for U.S. Treasury obligations. At this moment in time, the 10-year bond is priced to yield a return of 2.50% and this is the rate (plus an additional interest rate spread) that is used primarily to price 30-year fixed rate mortgages which are currently priced at 4.12%, give or take a few basis points.

Another interest rate that is good for folks to know is the “Prime Rate” which can be found daily in the Wall Street Journal.This rate is controlled by the Federal Reserve as they meet periodically to discuss and vote on whether to raise, lower, or keep this rate the same.Lately, this rate has seen a few small quarter point increases so it stands at 3.75% today.The Prime Rate is also the borrowing cost for money for a Prime Borrower and these tend to be the biggest and most stable customers of a bank.

Why is it important to know the current market interest rates?I’m glad you asked.The answer:to better judge an investment or lending opportunity so you can add an additional “risk premium” which is the spread above the “risk free” rates to help you determine the amount of risk you may be willing to assume for a potential higher return.

Currently, there are trillions of dollars sitting in low, zero, or negative interest rate accounts across the globe.Why?Because these are risk-averse dollars.The folks who control where this money sits want it to be liquid (so they can get their hands on it at a moments notice) and safe (so they know they will get their money back when they need it).

I am personally fed up when I hear financial salespeople telling people to expect an 8% (or 12%) average return on their money in the stock market based on past performance.These salespeople gloss over the risk factor in their discussion which is hard to quantify for many folks since it can be a very subjective number.Nevertheless, risk is still baked into the equation so it is better to be fore-armed and educated about this than to take someone’s unsubstantiated and clueless opinion regarding a value like an “average rate of return” on an investment.

I live in the southeastern portion of the United States and the average temperature where I live is recorded on the internet at 59 degrees.Currently, my I-phone temperature is reporting a temperature at 41 degrees at 1:18 pm.It is also January so you would not want to dress according to the average temperature in case it is below freezing, which can easily happen.The “average” is meaningless and it does not give you very much information so it is a bad idea to base any decisions on this one number, right?

Unfortunately, we are bombarded with averages and rules of thumb without verifying what the actual temperature is right now.This is a mistake.The other major item that people brush over is timing.If you average a 9% return over 40 years and are about to retire and the market crashes where you lost half of what you saved for retirement, would you be happy if the average return was 9%?Of course not!You just lost half of the money you were counting on to live and pay your bills for the rest of your life.

My advice to you is to know your risk tolerance and stay in your own lane without regard to what other people are doing or what the “experts” tell you to do.Since you are the only one who has to live with the consequences of the outcome of your decision, you need to be educated on what risk is and how much risk you are willing to take on and can afford to lose if you are wrong.

Once a person understands how much risk is appropriate for their particular investment style, a lot of things fall into place.Instead of accepting a 1% (or lower) return on your money, you might actually be comfortable with repositioning this same money and achieving a 10% return without taking on ten times the risk.

This exercise is relevant when a decision needs to be made when you are stepping out of your comfort zone the first time.Almost any rate of return is possible if you know what to do and how to do it.The expected and actual return needs to be compared with a baseline “risk-free” return.

A friend of mine told me about an investing opportunity whereby he could receive a return of 10%.This was a loan and the money was going to be used to purchase inventory for resale.As a commercial lender, I posed the question “If this small business owner could borrow money from their bank at a market interest rate (Prime Rate + 2.00% or 5.75%), then why would they borrow it from you at 10%?”

The answer is nobody would borrow money at 10% if they could borrow it at 5.75%.Why pay extra interest to someone else unless you had no other choice?In this case, the business owner could not borrow from their bank at a market rate (or more accurately, at any rate because they turned them down for an inventory loan).This should have been a red flag. If the bank, who is in business to make loans, has looked at the risk and decided not to lend the business money, and the bank has all sorts of documentation (financial statements, tax returns, credit reports, etc.) they review before deciding to decline the loan, why would someone take on this much risk without having reviewed the same documentation the bank required?Besides, the collateral was inventory and if the business could not sell the inventory (and that is what they did for a living) then how could a bank or investor do any better?

This is a real-life example of taking on risk but only looking at the expected return.If you don’t get all your money repaid, it would have been much better to leave the money in the bank at 1% interest.On the other hand, if you had a seasoned real estate investor who could buy a house well-below market value, fix it up, and sell it for a nice profit and pay the investor 10% during the time their money was used, there is not nearly the risk for the same expected return as the former scenario which contained a huge amount of risk.