In this article you will learn that not only products and services have a price, but also uncertainty, fear and risk.
Imagine, I take you to the swimming pool and ask you to make a plunge from a 10 meter diving board. If you are passionate high-diver and often make such dives, you will probably not hesitate and jump. However, if you hate swimming pools as much as I do and if the last thing that comes into your mind when you get out of bed in the early morning is to throw yourself into a puddle of water, you will certainly not agree to climb the tower and jump.
In that case, I have two options: either I renounce the spectacle of seeing you making a plunge, or I try to find a way to convince you to jump in spite of your concerns. As I am a nice guy, I’ll do this without using threats or brute force and rather promise you a reward, a piece of chocolate, perhaps, or two, or a pizza … depending. If the incentive is big enough, even if you are in a blue funk, you’ll probably be ready to jump.
The reward I’m offering you is nothing more than the price, the premium, that I pay so that you overcome your fear and do something that you actually do not want to do. Or, to say it with the title of a famous Italian-French movie of the 1950s, it is somehow “the wages of fear.”
Now imagine I am a banker and you want me to lend you money. If I have the certainty that you will pay me back my money at the moment in time we agreed upon, I will have no problem with lending you a certain amount of money.
If, however, I fear that you are not very reliable, that you’re going to waste the money I’ll lend you, that it is therefore highly uncertain that you will be able to pay back the money you have borrowed and that I risk to lose my money, then I will not be willing to give you a loan. Since you’re a nice guy as well, you exclude the alternative of a hold up and you are going to look for a more civilized way to convince me to anyway lend you the money you need.
But how? Well, by offering to pay me a premium, to pay me a much higher amount than the amount I’ll lend you. (It is true that in practice, it’s the banker who will require the payment of such a bonus and not the borrower who is going to offer it, but for understanding the principle, this is a negligible detail.) This premium is the price you have to pay for me to accept uncertainty and assume the risk that you will not refund me the money I’ll lend you. And the higher I consider this risk to be, the higher this premium will be. In finance, we call this premium a “risk premium”.
What lessons can we learn from this?
The lesson to learn: No return without risk
- If somebody offers you a “golden opportunity” that would allow you to realise an astronomical gain (or in financial jargon, a “return”) without any risk, then you can be sure that the suggested deal is anything but risk-free.Indeed, why should anybody voluntarily pay you an exceptionally high return (which, as we have seen, is nothing else than a risk premium)? If you can buy a new mobile phone for 100, you will not offer to pay 120. So if someone claims to guarantee you a huge return, he does so for two possible reasons:
- either there are experienced people who know how to correctly evaluate the proposed business, who feel it is very uncertain that it will succeed and that the risk of losing money is important and therefore require a higher risk premium to engage in this matter,
- or the one who offers you this “golden opportunity” is a crook and his promise of return is nothing but a bait to get your money and run away with it.
- High uncertainty and high risk therefore imply a high risk premium, and low risk means a low risk premium. So if you want to make a higher profit (achieve a higher return) with your investment, you have to accept more uncertainty and a higher risk. If you do not pay me a risk premium, I am not willing to take a risk, and if you’re not willing to take a risk I’m not willing to pay you a premium.