When it comes to making money, the formula is surprisingly quite simple. You need to look at cashflow. Yes, you can look at capital appreciation and try and make money on the asset base, or if you were feeling particularly frisky you might like the idea of ‘speculate to accumulate’, or you could just stick your money on the 3-legged horse ‘Pull Your Pants Down’ running out of starting gate 13 at Ascot. However, the sensible money is made through a strong appreciation and respect of those two eternal concepts of risk and return. Once you understand that everything (yes, I mean everything) has an element of risk attached to it then you can begin to evaluate whether the potential return on the investment works. In other words, is the trade-off worthwhile? When I brush my teeth in the morning there is a chance (however slim) that as I’m unscrewing the cap off my toothpaste, that my 6 and 8year old daughters run into the bathroom and knock my legs from behind me, sending me to my knees. The cap flies up out of my hand and into the air. As I fall to the bathroom floor the cap incredibly falls straight into the mouth which is wide open from the shock of being knocked to the floor, and yes, sadly I choke to death. The End. Pretty unrealistic? Yes. Absolutely impossible? No. And that’s my point. Nothing is impossible. Even if the odds of this scenario happening are perhaps 1 in 10 trillion, it could still happen and that’s a risk that I need to know. The ‘return’ of course is that I get to brush my teeth. So, is the trade workable? Does the trade make sense? The answer is yes it does because if it didn’t work then I wouldn’t brush my teeth. I know that this is very far-fetched but this is the starting point that you should consider if you want to understand risk and return. Let’s think of another one. Every time that you cross the road do you put your life at risk? Yes. There is a risk that you could get run over but the risk is (hopefully) very small because you look both ways and don’t walk into oncoming traffic. And without realising it, your mind has already calculated that the return on your investment (getting to the other side of the street) is worth that risk. As humans we make these decisions on risk and return every second of every minute of every day, we just don’t know it. My baby boy, Fateh Singh, turned the ripe old age of 7 months just a few days ago, and you can see that already he is understanding about risk and return. If he does something which causes him pain, for example like banging his plastic toy in a certain way such that it hits him, his immediate reaction will be to stop doing that action. The next time he has that toy he will have probably forgotten that this particular swinging action caused him pain and he will do it again – until he hits himself again, and then he will stop. It won’t take long for him to realise those actions which give him pleasure and those which give him pain. That’s built-in to his DNA over tens of thousands of years – that is the amazing human body of course. It’s the same with animals and even plants. We strive pleasure and we shy away from pain. That allows us to survive and reproduce and pass on those genes to the next generation. It was never my intention to make trading sound like a biology lesson but actually maybe it should. That’s because part of the problem that most investors face is that they do not understand about trading or investing because society puts it these concepts into this separate bubble called ‘finance’ which sound difficult. Straight away it becomes unreachable for some people, and for others still it sounds complicated and too much like hard work. In severe cases some people freeze in just the thought of it. But it shouldn’t be like that. Investing like life is about risk and return. You have to mitigate the risk and you have to get the best return. The people who are the most successful investors are those who pick the best stocks, have the best timing, and create the best strategies. But what helps them to achieve all of this? – well, it’s the same thing – they understand the return to risk pay-off. In today’s video I talk about how to mitigate risk through focussing on cash flow, whether that be dividends, rental income, coupon payments or just bank interest. However, these technical terms all mean the same thing – they help you to reduce risk. So, if the return can remain fixed and the risk can fall, then guess what? Yes, that’s right you are about to get rich.