Introduction

Formulate a Financial Plan

Know Your Net Worth

Manage & Minimize Debt

Accumulate Assets

Budget to Live Within Your Means

Understand Investing Basics

Plan for Retirement

Insure People & Property

Deal with Financial Advisors

Review Your Employment Contract

Make Plans for Your Estate

Make Good Decisions

Conclusion

Financial decisions ultimately boil down to two simultaneous considerations:

  1. How much risk is involved, and
  2. How much reward or return is expected

Doctors understand the interplay between risk and reward. There are often multiple treatment options for a given patient. Each choice is accompanied by some amount of risk and some potential gain in terms of improved health. The key is to form a judgment about which choice yields the superior tradeoff.

Decisions in any setting, be it medical, financial, political, etc., must consider both risk and return. This is a crucial observation. Sellers of financial products and services invariably try to get you to focus on one or the other. They try to tempt you using the “greed” motive by focusing on rewards or returns, or they try to scare you using the “fear” motive by focusing on risk. You must always insist on considering both together, in balanced fashion. The golden rule of financial decision-making is: always make decisions based on simultaneous and objective consideration of risk and return.

 

What is Risk?

Risk is present when we engage in activities that yield uncertain outcomes with potentially negative consequences.

Consider rolling a pair of dice or tossing a coin. You’re uncertain about which numbers between one and six the dice will settle on, or whether the coin will land on “heads” or “tails.” When at least one outcome has negative consequences, you face risk. For example, if you bet money on the dice roll or coin toss outcome, you are facing risk. On the other hand, if there’s no money at stake—that is, no downside—we would say the situation is uncertain, but not strictly speaking risky.

More generally, a negative outcome may arise in the form of financial loss, property destruction, physical injury, reputational damage, emotional setback, etc. We will focus on financial losses.[1]

Some risky scenarios such as the dice roll or coin toss may exhibit only a handful of distinct potential outcomes {1, 2, 3, 4, 5, 6} or {heads, tails}. When you invest in the stock market there are potentially many negative outcomes (theoretically an infinite number),  covering a wide range of potential gains and losses. When you start your own private practice, you face various risks, with a wide range of potential positive and negative earnings outcomes, including the extreme possibility of bankruptcy.

Investments expose us to what is known as Speculative Risk. According to Investopedia:

"Speculative risk is a category of risk that, when undertaken, results in an uncertain degree of gain or loss. All speculative risks are made as conscious choices and are not just a result of uncontrollable circumstances."

In other words, we consciously choose to take on speculative risk, motivated by potential upside or financial gain. When we discuss insurance we’ll cover a different kind of risk known as pure risk.

 

Likelihood and Severity

Risk is often divided into two dimensions:

  1. The probability or likelihood of a negative outcome occurring, and
  2. The severity of damage or loss in the event a negative outcome occurs

For example, a bank considers lending money to a medical practice. The first dimension of risk the bank faces is the possibility that the borrowing practice will go bankrupt—this is the probability of the negative outcome. The second dimension is the amount of the loan that may be lost due to the bankruptcy—this is the severity of the negative outcome.

To mitigate the first dimension (the probability of default), the bank will closely examine the medical practice’s proposed business plan, its intended location, the experience and credibility of its management team, etc. To mitigate the second dimension (the size of the loss), the bank will demand collateral: including specific assets to secure the loan, such as real estate, equipment, inventory, etc. 

 

What is Financial Gain or Return?

Return refers to the upside, profit, or benefit we seek from participating in some activity. The return or reward may be physical, emotional, or financial. In our financial context the risky activity is investing, and the upside comes in the form of favorable investment returns.

Investment returns come in several forms:

  1. Income we receive on investments (dividends received on stocks, interest received on bonds, or rent payments on property we own), and
  2. Capital gains from selling assets (stocks, real estate, a medical practice) at prices that are higher than what we paid for them

Consistently generating positive returns on investments helps to steadily grow our pillars of wealth. 

When we initiate a risky investment we have some sense of the range of possible return outcomes. Our best guess of what the return will be is the expected return. Mathematically, the expected return is typically an average of the various potential return outcomes. Once the investment’s outcome has been determined, we know exactly what we’ve gained (or lost) and this quantity is known as the realized return. The realized return may be higher or lower than the expected return.

Investors dream of finding high expected return investments with low risk. While unscrupulous advisors may claim they can offer such deals, market realities make them highly unlikely. The low probability of such mythical opportunities gives rise to the cautionary expression: There’s no free lunch on Wall Street.

A fundamental tenet of finance is that the expected return of an investment must be commensurate with the risk undertaken.

Thus, we should only accept a very risky investment if there is a reasonable expectation that it will yield a very high return. It follows that we should expect a low return on a low-risk investment.

For example, high yield bonds, as the name implies, offer higher yields or expected returns than investment grade bonds. The former are issued by firms with low creditworthiness and hence higher risk while the latter are issued by firms with more stable prospects. Alternatively, stocks issued by very small firms are generally riskier than stocks issued by much larger and more established corporations. Investments in the former are expected to provide a higher return than investments in the latter.

Typically, we allocate our wealth to a range of investments, some of which offer higher returns at higher risk, and others offering lower returns at lower risk. Each person’s risk tolerance, or comfort level with risk, influences her decision regarding how much overall risk to take.

 


[1] Doctors face all these potential negative outcomes—not just financial ones. All are relevant when it comes to wellness.


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