From the course: Corporate Finance Foundations

What is risk and why don't we like it?

From the course: Corporate Finance Foundations

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What is risk and why don't we like it?

- Let's talk about risk. First, what is risk? Risk is uncertainty about what will happen in the future. - Now in the future, there will be a variability as to the possible outcomes. We make an investment in a product, we hire a key person, or we build a building. It could go well, it could go poorly. - Variability in potential outcomes is what we call risk. - Now, consider a commercial real estate investment. I can build a commercial real estate building and rent it out to tenants. The building can be in the heart of the business district where there are many potential tenants. I'm pretty confident that I'd be able to rent space in that building. - On the other hand, let's suppose I'm considering building a commercial building in an industrial park at the edge of town. Now, when I say edge of town, I mean it's out there. Nobody is there yet. There are weeds on the lot. Tenants may come in or not. I'm not sure. There is much more risk, much more variability in potential outcomes out there on the edge of town. - Some risk is an unwanted side effect of doing business. For example, if I'm in the airline business, a big risk is the uncertain cost of jet fuel. Because I'm in the airline industry, I am subject to price risk related to fuel prices. - On the other hand, there are companies who are in existence for the very purpose of helping individuals and other companies manage risk. - For example, insurance companies exist because of risk. It is their job to take risk from me and assume it on themselves and I'll pay them for that. - Now as humans, typically, we don't like risk, but there are counter examples. Extreme sportspeople and Himalayan mountain climbers, they seem to seek out risk. - But most humans don't like risk, particularly in their everyday lives. That's why we have such things as health insurance and life insurance. - [Glasses Man] The key point is this, people typically need to be paid to get them to accept risk. I might accept more risk if you pay me. - Now let's take some examples from business. For example, if you go down to your friendly neighborhood bank and invest money in a savings account that's insured by the FDIC, you can expect a return of less than 1%. Why such a low return? Well, there's a low risk. - [Glasses Man] Now, if you elect to invest in a corporate bond, you can expect a return of about 4%. Why a higher return? It's a little more risky. It's not guaranteed by the government. - And if you elect to invest in a stock index fund, you can expect an average return of about 10%. Why so much higher? Because it's riskier. That index fund could go up if the market goes up, but it could go down if the market goes down. - Remember this key point. In order to get me to accept more risk, you're going to need to entice me with higher expected returns.

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