Decisions are something we have to be aware of and make every single day of our lives. Whether they are small, seemingly unimportant decisions like brushing our teeth or going to bed early, or big ones like choosing a major or declining a job offer, our decisions shape our future and our personality. With every decision comes an outcome… and a share of risk that we need to take into account before making a move. And yes, we all have trouble making big decisions and wish we could understand the situation better… that’s why we’re here today!
In finance, risk means the degree of uncertainty or the probability of failure that’s inherent in an investment decision. When we invest our money in stocks (for example), there is a certain amount of risk associated to those stocks, which means there is a chance we’ll lose our money. The higher the risk, the more likely we are to lose our investment, but the return we can get for our investment will be higher too. Risk can come in many shapes, such as inflation risk or liquidity risk among others, but let’s focus on the definition we’ve just given.
We know risk is the probability of us losing our money, and we want to maximize our return while minimizing our risk (if this does not suit you, you are a bit crazy!). In the 60s, William F. Sharpe created a way to measure how profitable an investment was according to its risk level, so that we could tell whether a certain asset was undervalued or overvalued, and make our decision based on the result. The Sharpe Ratio works as follows:
E is the expected value of the difference (excess) between the asset return and the “risk-free” return (more a concept than a real thing, but we normally use government bonds as an example of “risk-free” assets. We can also use savings accounts as examples of “risk-free” assets). is the standard deviation of the asset we are analyzing (i.e. the difference between all the possible final results and the central “expected” value). If our asset’s risk is very low and the return is very high, its Sharpe ratio will be very high as well, and vice versa. Therefore, when comparing several assets, we’ll choose the one(s) with the higher Sharpe ratios.
Back to real life now. How is this helpful for us? I know many of our decisions don’t involve assets or money in general, but we can create and use our own Sharpe ratios to weigh the pros and cons of every decision. Here is an example I’ve come up with to explain it better:
The key to understanding how to make decisions the Economic way is to know and predict every possible outcome and choose what suits your risk profile better. You’ll always have your “risk-free” asset, which is not making a decision, but even that decision of not making any decisions will get you to an outcome and you must add that scenario to the equation in order to have an unbiased view of your problems.