Understanding risk vs. return

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One of the key concepts that i try to teach in the classroom and at extension meetings is the trade-off between risk and return that exists in capital markets. The trade-off is based on three assumptions:

  • Individuals prefer increased returns.
  • Individuals are “risk averse” and, therefore, prefer to avoid risks.
  • Risk and return are related and, therefore, move in tandem. For example, generally avoiding risk comes at the expense of higher returns, while generating higher returns comes with more risk.

Whenever I discuss this risk/return trade-off, someone usually asks: What’s the right balance between risk and return?  Unfortunately there is no single “right” answer  — the answer lies within each individual.

For persons who are uncomfortable taking risks, the correct actions are those that yield a lower return, but also have less risk. Alternatively, persons who are comfortable taking risks are probably wise to take on projects that yield a higher return, but also come with higher risk.

Two ways of thinking

Within the dairy industry, there are currently two camps with vastly different attitudes regarding risk and return. One camp includes dairy operations that focus on low-input production practices, such as grazing. They make minimal investments in assets like machinery and facilities and are, therefore, able to borrow sparingly.

The other camp includes farms that make extensive use of state-of-the-art technologies and capital assets to achieve high productivity and efficiencies. The farms in this latter group are typically large-scale confinement operations that are highly leveraged because large amounts of credit are typically used to finance investments in cows, facilities, machinery and equipment.

Each of these production systems has its own advantages and disadvantages. The grass-based dairies tend to be less risky because their overall investment in assets is relatively low and, therefore, the debt loads are minimal. However, these lower risks generally result in lower returns.

The confinement-based dairies clearly have greater overall risk. They have large amounts of money invested in parlors, barns and equipment.  But these investments are used to get high volumes of milk from cows and generate higher returns. So in most cases, the reward for taking risk and investing in a confinement operation yields a proportional increase in return.

What’s right for you?

When it comes to selecting a dairy-production system, there is no “right” or “wrong” answer. Business decisions must be based on an individual’s attitude towards risk and return.

Persons with high aversion to risk are “right” to select less-risky dairy systems. Meanwhile, persons who are comfortable with risk are “right” to choose capital-intensive operations that yield higher returns as compensation for taking higher risks. 

The selection of a dairy-production system, or of any other investment project, cannot be determined solely by profit or rate-of-return. Your risk tolerance must also be considered.

Each of us must decide what is “best,” given our own values, risk tolerances and skill sets. Whether it’s a grass-based dairy or a large-scale confinement operation, both production systems can be successful in the hands of the “right” manager.

Choose the path that you believe will keep risk at the “right” level and give you the best chance to succeed.

Bruce Jones is professor of farm management at the University of Wisconsin-Madison.

 

 



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