* The charts referenced below appear at the bottom of the article
The top wheel has five possible outcomes with four of them returning 6 percent and one returning 1 percent. The bottom wheel also has five possible outcomes, but they range from 2 percent to 12 percent.
If you spin both wheels, which one is riskier?
If you ask people which wheel has the greatest risk, most people say it is the bottom one. And they are right if you only spin the wheels once.
On one spin of the wheel, the top wheel has a 20 percent chance of returning less than 6 percent and the bottom wheel has a 60 percent chance of returning less than 6 percent. On one spin of the wheel, the bottom wheel poses the greatest risk of low returns.
However, a consumer’s financial world does not consist of one spin of the wheel. A consumer is not taking all of his IRA money and betting it all on how the market does tomorrow. In reality, our financial world is made up of thousands of spins of the wheel.
Not understanding risk and volatility
If you spin our two wheels many times, the bottom one produces the higher return and is therefore less risky than the top one. Unfortunately, we assume the bottom wheel is riskier because it is more volatile, and because we see the future as one spin of the wheel at a time we confuse volatility and risk. Not understanding the difference between risk and volatility often sabotages financial plans by causing us to not maximize potential earnings.