Introduction to Risk and Return

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J: Let’s talk about risk. Uncertainty. Variability.

K: OK. I’m scared, but let’s talk about it.

J: Let’s say that you were running an airline. What risks would you face? In other words, what uncertainties would you have to consider as you made your business plans?

K: Here are some risks.

-  Uncertain passenger demand based on ebbs and flows in the global economy and also ebbs and flows in concerns about security and safety.

-  Uncertainty about what my competitors might do. Will they merge? Will they cut prices to compete with me on my most important routes?

-  Fuel prices

-  Employee strikes

-  Technology outages

Yeah, there are lots of risks associated with running an airline.

J: OK. So, let’s say that you were planning to gather up all of your life savings and use it to start your own airline.

K: Well, it would have to be a pretty small airline. How about if we combine our life savings, yours and mine? With the massive influx of cash from your savings, we would have enough to start a pretty fair-size airline.

J: Fine. You and I use our life savings to start an airline. We know about all of the risks that you just listed. So, what kind of return would we expect on our investment?

K: Return? What do you mean?

J: Well, if we just took our savings down to the local bank and put it in a savings account, we would get a return of 0.10%. If instead we use the savings to start our airline, would we expect a higher return or a lower return?

K: A higher return. MUCH higher.

J: Why?

K: Because of the risks. The savings account is pretty much risk free. But the investment in the airline? Very uncertain. I’m going to expect a much higher return to induce me into such a risky investment.

J: Exactly. There is a connection between RISK and RETURN. Let’s talk about that connection.