Probabilities and Peanut Butter


How I’m saving for my new daughter's future- Part 2: Risk vs Return

Probabilities and Peanut Butter


Life is risky. But just how risky?


This is the second blog in a short series on how I’m saving for my new daughter’s future. If you haven’t read the first blog, it would be a great place to start.



Probabilities and Peanut Butter


During the 1970s, Ronald Howard and his team at Stanford University developed a measurement to analyse just how risky certain activities in life are. Their method was to use the “micromort” -a one in a million chance of death – as a measurement of this risk.

Take skydiving. One skydiver has 8 micromorts. An 8 in a million chance of dying from doing one skydive. Driving a car for 400km has 1 micromort. A 1 in a million chance. Running a marathon has 7 micromorts.

Eating a thousand bananas increases your risk of dying by 1 micromort (It’s something to do with their potassium levels). So does eating 40 tablespoons of peanut butter or drinking half a litre of wine (what a Friday night that was!).



Why am I telling you this? Well, it’s to illustrate the fact that everything in life carries a degree of risk. We accept it. When we get out of bed, cross the road or eat 40 tablespoons of peanut butter, we just don’t see it as a risk. It’s also to illustrate that risk is measurable, and we can (and do) make calculated decisions, each and every day depending on the level of risk that they involve.

We’re comfortable with risk in everyday life, so why not with finance?

Risk vs Return

Risk and return are contrasting concepts in the world of money. Return is how much money you get back, risk is how likely you are to get it

In general, at low levels of risk the returns will be much lower, the higher the risk you’ll accept, the greater the potential return. Look at this graph:


As the risk goes up, so does the potential return. To get more money back, you have to accept a higher level of risk.

For example, a normal savings account at the moment. 0.5% interest. That’s 50p back in a year for every £100 you put in. Maybe a bit more if you’re lucky and put the right money in at the right time. Not a high return at all. But very little risk. There’s little chance that you’ll lose all of the money you put in.

Contrast that with something like bitcoin. The virtual money that is advertised all over the internet. You could choose to invest your money in it.

If you’d put in £100 into bitcoin at the start of 2017 it would have been worth £1,000 by the end of the year (approx. figures- rounded). But if you’d bought £100 of bitcoin at the start of 2018, it would be worth £50 by the end of March 2018. There is a much higher rate of return for accepting a greater risk. You might make 10x your original money, but you might lose it. No one knows what the prices will do in the future, bitcoin in particular goes up and down all the time.

Some people might be happy with the relative security of 0.5%, others would be up for a gamble. Any number of factors can come into play when deciding how to balance the risk and the return. Your age, income, family situation, general attitude, experience all come into play when determining how much risk you’ll accept.

The solution?

As part of saving I want my money to do some work for me, I don’t want a measly 0.5% interest each year. But equally I don’t want to gamble it away. Somewhere in the middle would be much better. Preferably a little closer to the bank account than to bitcoin.

It’s important to work out how much risk you are comfortable with. I’m very risk adverse. I like guarantees, certainty. Particularly with money. What that middle ground looks for me is what the next blog post in this series will look at.

In life is that there are no guarantees. The level of certainty we think we have is often an illusion. As the micromort illustrates, there’s more risk in the everyday than you think. Jobs, houses, savings, the things we count on as certain can be anything but. There’s still risk there.

As we become more aware of the risks all around, perhaps that helps us to accept a slightly increased level of risk with our finances too. In the expectation that the greater risk will result in a greater return.

And I might just have that peanut butter after all.


To get first look at the final post in this series give the facebook page a like:  https://www.facebook.com/doughmoneyblog/




Comments

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