Sec.2. The Payment for Risk-bearing.  There is another element of great importance about which our ordinary ideas are apt to be so vague that it will be well to devote a chapter to its examination.  This is the element of payment for risk, or rather the reward of risk-bearing.  Risk is inherent in all business, as it is inherent in all life.  The vagaries of nature and the vagaries of man are alike responsible.  The farmer may find his harvest ruined by a drought or by a deluge; the coal or the gold, for the extraction of which you have perhaps set up an extensive mining plant, may come to an end which is unexpectedly abrupt.  You may put your money into roller-skating rinks and find that cinemas have become the rage with the fickle public; sometimes “the market” may decline for causes which remain obscure but with consequences which are disagreeably plain.  But while risk is always present in some degree, the degree varies enormously from one industry to another.  Now, it is obvious enough that in an exceptionally risky industry, where there is a considerable possibility that the capital invested will yield no return at all, the profits of those concerns which succeed are likely to exceed the rate of interest on gilt-edged securities.  But what is likely to be the magnitude of this excess?  Is risk-taking rewarded if there is any such excess, however small?  Or will it suffice that the gains and losses should average out to a fair rate of interest over the whole industry?  To enable us to think closely let us suppose for a moment that we can measure accurately what the chances are.

Suppose, then, that there were a precisely equal chance of success on the one hand and failure on the other in any enterprise, failure involving a complete loss of all the capital invested.  Suppose, further, 6 per cent to be at the time a fair return on a perfectly secure investment.  What would be the return which must be expected from the risky enterprise, in the event of its succeeding, before it will be undertaken?  The reader may be tempted to answer, 12 per cent.  But 12 per cent would not suffice.  An equal chance of 12 per cent or nothing, as compared with a certainty of 6 per cent, does not mean that the risk in the former case is paid for to the tune of 6 per cent.  It means that it is not paid for at all.  In each case what a mathematician would call the expectation is a return of 6 per cent.  The odds are evenly balanced; in the long run, over a large number of cases, if the law of averages works as we assume it does, you would get just as much from the one type of investment as the other.  Now, risky enterprises will not, as a rule, be undertaken on terms like these; investors and business men will not take risks with the odds precisely equal; they must have them, or believe that they have them, in their favor.