Key terms

• Bond: A legal commitment to pay fixed amounts of money on a fixed date, whether the business is making money or losing money

• Stock: A share of the business that issues them with no guarantee that the company will make a profit or payout dividends instead of reinvesting their profits

• Risk: The chance that an investment’s actual return will differ from what is expected

• Diversification: The strategy of investing across various forms of investment to reduce the exposure to any one particular asset or risk.

• Insurance: A legal commitment to provide a guarantee of compensation for specified loss, damage, illness, or death in return for payment of a premium.

• Moral Hazard: The risk that a party within a contract acts in bad faith or takes unusual risks as they are unlikely to suffer consequences

• Adverse Selection: The tendency of high-risk parties to get insurance or when.

• Government Insurance: Government programs that deal with risk are often analogized to insurance, or may even be officially called “insurance” without in fact being insurance.

Variable Returns Vs Fixed Returns:

• Stocks and bonds are among the many ways of dealing with differing risks, but people who are not considering buying these financial securities must nevertheless confront the same principles in other ways, when choosing a career for themselves or when considering public policy issues for the country as a whole.

• Bonds differ from stocks because bonds are legal commitments to pay fixed amounts of money on a fixed date.

• Stocks are simply shares of the business that issues them, and there is no guarantee that the business will make a profit in the first place, much less pay out dividends instead of re-investing their profits in the business itself.

• Bondholders have a legal right to be paid what they were promised, whether the business is making money or losing money.

• People who set up businesses may not only fail to make a profit but may even lose part or all of what they originally invested.

• If you buy bonds, your chances are still only 50–50 of getting all your money back and if this enterprise prospers, you are only entitled to whatever rate of return was specified in the bond at the outset, no matter how many millions of dollars the entrepreneur makes with your money.

• If the business goes bankrupt, your stock could be worthless, while a bond would have some residual value, based on whatever assets might remain to be sold, even if that only pays the bondholders and other creditors pennies on the dollar.

• This is the kind of investment often called “venture capital,” as distinguished from buying the stocks or bonds of some long-established corporation that is unlikely to either go bankrupt or to have a spectacular rate of return on its investments.

• Knowing that bonds would be unattractive to investors and that a bank would likewise be reluctant to lend to him because of the high risks, the entrepreneur would almost certainly try to raise money by selling stocks instead.

• A more common pattern among those businesses that succeed is one of low income or no income at the beginning, followed by higher earnings after the enterprise develops a clientele and establishes a reputation.

• The stock market as a whole is not as risky as commodity speculation or venture capital but neither is it a model of stability.

• The various degrees and varieties of risk can be dealt with by having a variety of investments—a “portfolio,” as they say—so that when one kind of investment is not doing well, other kinds may be flourishing, thereby reducing the over-all risk to your total assets.

• A portfolio consisting mostly—or even solely—of stocks can have its risks reduced by having a mixture of stocks from different companies that may be a group of stocks selected by a professional investor who charges others for selecting and managing their money in what is called a “mutual fund.”

• People who accept jobs with no pay, or with pay much less than they could have gotten elsewhere, are in effect investing their working time, rather than money, in hopes of a larger future return than they would get by accepting a job that pays a higher salary initially.

Insurance:

• After first dealing with the principles on which insurance has operated for centuries, we can then see the difference between insurance and various other programs which have arisen in more recent times and have been called “insurance” in political rhetoric.

• Like commodity speculators, insurance companies deal with inherent and inescapable risks and insurance both transfers and reduces those risks.

• The most common kind of insurance—life insurance—compensates for a misfortune that cannot be prevented.

• What makes life insurance different from a bond is that neither the individual insured nor the insurance company knows when that particular individual will die.

• The insurance policy is worth more to the buyer than it costs the seller because the seller’s risk is less than the risk that the buyer would face without insurance.

• There is no point transferring a risk that is not reduced in the process, because the insurer must charge as much as the risk would cost the insured—plus enough more to pay the administrative costs of doing business and still leave a profit to the insurer.

• The insurance companies will have more money available than if they had let the money they receive from policy-holders gather dust in a vault, because the insurance companies can then invest what is left over after paying claims and other costs of doing business.

• While it might seem that an insurance company could just keep the profit from its investments for itself, in reality competition forces the price of insurance down, as it forces other prices down, to a level that will cover costs and provide a rate of return sufficient to compensate investors, without attracting additional competing investment.

• Although determining costs and probabilities for various kinds of insurance involve complex statistical calculations of risk, this can never be reduced to a pure science because of such unpredictable things as changes in behavior caused by the insurance itself as well as differences among people who choose or do not choose to be insured against a given risk.

• Government regulation can either increase or decrease the risks faced by insurance companies and their customers.

• Government regulation can also adversely affect insurance companies and their customers when insurance principles conflict with political principles.

• Laws forbidding risks to be reflected in insurance premiums and coverage mean that premiums in general must rise, not only to cover higher uncertainties when knowledge of certain risks is banned, but also to cover the cost of increased litigation from policy-holders who claim discrimination, whether or not such claims turn out to be true.