One of the fundamental laws of the universe, is the Law of Gravity. Einstein taught us that gravity is the bending of space/time, which we perceive as objects being drawn toward each other.
Finance's "Law of Gravity" is the idea of the relationship between risk and return. The idea is pretty straight forward: The riskier the investment, the potential greater the return. Said another way, the lower the risk, the lower the expected return. The relationship between risk and return is positivity correlated, therefore the more an investor is willing to dial up their risk, the more return they expect to make.
Let's take two relatively straight forward examples which will clearly reveal the gravity law in finance.
Low Risk example: Putting your money in your local FDIC insured bank is a extremely safe investment. In a nut shell, there is next to no chance that you will lose your principal amount (up to the FDIC limit of course). For this ultra safe investment, investors today are earning between 0.0% - 0.50% (annually).
Keep in mind, when you factor in inflation, this 'safe' investment actually loses purchasing power over time - but this for another conversation (read here) which talks about inflation and its effect on purchasing power.
High Risk example: Taking this same money out of your bank and placing all of it on one hand of Black Jack at your favorite casino. The risk is extremely high that you will lose all of your money on that single bet, however, there is a chance that you will 'win' your bet and double your money in an extremely short period of time - a great return over an extremely short period of time. So this high risk action has the potential of high returns.
So next time you hear of an investment opportunity that sounds 'too good to be true,' take a minute to think of the simple relationship that return = risk.
-Paul R. Rossi, CFA
Paul R. Rossi, CFA