Friday, February 03, 2006

Lower the risk, Higher the Return

In most scenarios, a greater risk is associated with a higher return and vice-versa. It's only in value investing that you'll find the very opposite picture. Let put this hypothesis to the test -

It's your first trip to New Delhi and you pick Karol Bagh (of all places) to shop. A stroll down Ajmal Khan Road and the crowd there, make you wonder why you would choose this of a thousand other places. On reaching the westend (where you have the Bata and Roshan-di-Kulfi shop), you come across a lane where two vendors are selling shirts. Equal in size, in colour, in quality and both are worth 100 rupees. So you know that you can sell the shirt to someone else at 100 rupees. Since it's off season, vendor A sells it at rupees 45 and vendor B sells the same shirts at rupees 60.

Which is more riskier - buying the shirt from A at 45 rupees or B at 60 rupees?

90% of all people I have asked this question have said "60 rupees". Think again. It's better to shell out 45 rupees for a 100 rupee shirt or 60 rupees for a 100 rupee shirt. A value investor (and most people) would be more comfortable paying 45 rupees than paying a higher sum of 60 rupees.

But where are the returns higher?

a) When you buy the shirt from A - Risk = 45 rupees; Return = 55 rupees
b) When you buy the shirt from B - Risk = 60 rupees; Return = 40 rupees

... which means lower the risk, higher the return (and vice-versa)

Howzzat !!!


Anonymous Partha said...

Ahaa . good one , am impressed.

3:05 AM  
Anonymous floyd said...

Duh ! the risks are not different if the shirts are identical. they (the shirts) are just temporarily mis-priced. which ends up creating an arbitrage opportunity if it interests one as such. eventually, they will be priced pretty close to each other.

4:13 AM  

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