It’s nice when things just fit together and the world around us makes sense. It speaks to our basic need for answers–and our appreciation of tidiness. The scientific community has been on an endless hunt for a theory that ties together the key forces around us. If found, the Theory of Everything will change the way we see the universe.
Compared to five years ago (even 18 months ago), the financial world has not only flipped on its head, but has done cartwheels, back flips, and has learned to briefly fly. For many markets, we can no longer rely on past data to predict the risk and returns of a given investment. The lowest risk investments offer essentially no return, and the highest risk investments are skyrocketing–and possibly exploding in a fireball that was your money.
However, before we panic, it’s important to ground ourselves in the financial “theory of everything”: Any investment is nothing more than a gamble, based on a combination of risk, return, and the variance of each. In other words, if you invest a certain amount you can expect X% return, and there is Y% risk you will lose some/all of it.
To make it more complicated, both the risk and return can vary wildly compared to the average. In other words, if you invested in Bitcoin over the last two years it was either an amazing or terrible decision, depending on when you bought and sold it–the overall rise was far from steady, and will likely change drastically many more times.
Risk, return, and variation matter, but the formula is the same whether you invest in T-Bills, stock indexes, local bonds, cryptocurrency, or yield farming. In fact, gambling itself fits into this basic formula as well.
For “luck” based games, the average return is negative, the average risk is high, and the variability is just enough to tease out the occasional jackpot.
There is another type of gambling that uses the risk/return formula but favors the skilled player: poker. If you have some…