Risk and Reward

The lowest-risk investment you can make is to lend money to the Government. It's vanishingly unlikely that the Government will be unable to repay its debts. So your capital is very safe: virtually no risk of losing it. Because many people want this level of safety, the Government doesn't have to offer much of a reward to get people to invest: it pays the lowest level of interest on the capital.

Companies which need funds cannot match that level of security: companies do go insolvent, even the largest, and thus there is always a greater risk of losing some or all of your capital if you lend to a company. So companies are thus forced to pay a higher rate of interest to get people to lend money to them.

So there is a direct relationship between risk and reward: the lower the risk, the lower the reward, and the higher the risk, the higher the reward. It's important to remember this, because salesmen and other unscrupulous individuals often try to paint high-reward investments as "low-risk" to get naive people to invest. But they can't be low-risk. If they were, the promoters would not need to pay high returns, because there is lots and lots of money looking for low-risk investments (pension funds mainly), and they would have no problems getting investors.

The fact is that low-risk is very hard to do. If you're not the Government, the only way to do it is to build a very large and very stable company, over many years, with a solid track record of consistent returns and prudent financial management. Because it's hard to do, there is a shortage of it, and newer companies need to attract funds by paying a higher return, until they have built up the track record that will enable them to qualify as lower-risk.

So the next time your mate tells you about a sure-fire, zero-risk investment that's paying 20% per annum, just tell him there's no such thing. Zero-risk investments never pay much above the bank rate, and investments that have to pay 20% returns to get funds must be so risky that you're one step away from gambling: what brokers euphemistically call "highly speculative". You're very likely to get no return at all, and lose your investment as well.