|You expect different returns on
different investments. Uncertainty is the factor that causes
this to happen.
If you lend £100 to the government at 6% you will have a return
of 6%. Short of invasion or revolution, this return is certain.
(Ha! This first written in 2008).
Suppose you lend £100 to the government for one year on the
following terms: at the end of the year the Chancellor will toss
a coin; if it comes down heads you will get your money back; if
it comes down tails you will get 112% of your money back. Your average
return is 6%. (The mathematician might say that your 'expected'
return is 6%). But your actual return could be 0% or 12%. Your return
Which investment would you rather make?
The price of uncertainty
Obviously, you would prefer the certain 6%. (We
have to pretend, for the serious business of investment, that gambling
But what if the Chancellor offers 114% if it comes
down tails? You would now expect to make 7% (average of 14 and zero)
- an extra 1%. Would you do it? You would? Then how about 113% for
tails? Now you expect only an extra 1/2%. Would you do that?
This cameo illustrates one of the key investment judgements.
Does the extra return being promised offer sufficient compensation
for the uncertainty of the promise? (In Advanced Investing this
will be called the 'trade-off between risk and return').
Uncertainty = Risk
The word always used to describe uncertainty in investment is 'risk'.
You might think that this is a word that is better
reserved for things like loans to Dodgy Bank PLC (DBPLC). You would
not lend money to DBPLC at 6% when you could get the same rate from
the government. This seems different from the Chancellor coin-tossing
example somehow - more obviously 'risky'.
Well it is. But that's because in lending to DBPLC
you are risking your capital and not just the interest on your capital:
the stakes are higher.
But the principle is the same. You might judge there
is a 1% chance of DBPLC defaulting within a year. So you need 7%
(=6% + 1%) to break even. And you need more than that to compensate
for the uncertainty. 8%? 9%? That's for you to decide. Either way
this is just like the earlier example except that God (or maybe
the managers of DBPLC) is tossing the coin.