Header Ads

Risk equals riches

Why do the rich get richer?


This is a question that is often asked my poorer people wondering why they don't get a fair deal in life. Why does it appear that those who are already living a fortuned existence continue to find that fortune favours them? Often comments such as these are either amused upon, ignored or else belittled as a silly fantasy. But might there be some trust to the question?

Ways to build wealth


There are three ways to build wealth. One, to slowly grow your wealth over time, ensuring that income exceeds expenditure and investing the excess. Two, win a lottery or a big premium bond win. Three, take some big gambles that pay off.

Understandably I would advocate the slow and steady approach outlined in the first method. However, there are those out there who grow their wealth to dizzying heights by taking on supernormal levels of risk. It is these people that cultivate the idea that the rich get richer.

Why can rich people take on big risks?


Only the rich can take the high risk strategy of investing in risky asset classes or taking a gamble. They have far more capital to be able lose. More crucially, they can afford to lose quite a few times before the strike it lucky.

The coin toss


I'll pick an extreme case for illustration. Let's say that we have two people in very different financial circumstances. We will assess their ability to take on risk.

Person A is an office worker with net assets of £10,000. Person B is a young inheritor of a vast wealth. Person B has net assets of £1,000,000.

Both are offered a high risk investment opportunity by their wealth manager. Invest £5,000 and there is a 50% chance that in a year the investment will be worth £50,000, ten times as much. However, if the investment doesn't pay off, it will be worth nothing.

Clearly, person A cannot afford half of their wealth on this high risk investment. Despite the fact that the expected investment return is £25,000 (50% * £50,000), person A only has two goes as the investment before they are wiped out. Not worth the risk.

Person B could potentially have 200 attempts at the high risk investment before they are wiped out. Given the number of attempts that person B could have it is more likely that person B will take on the investment. If it fails, person be has lost 0.5% of their wealth and can give the investment another go. 

Over time the likelihood is that the investment will work out in person B's favour and provide a positive outcome. In theory, person B can reason that they can give the investment at least five attempts to try to prevail. After four attempts, they will have spent £20,000 but if successful on the fifth attempt then they would still have made an overall profit of £5,000.

Given person B's ability to take on risk, it is clear why the rich get richer.

No comments