One of the defining moments of my current perception on personal finances, and market behavior in general, is when I first read something similar to the following:

• Wealth does not come from a diversified portfolio. Rather, true wealth is created by taking on concentrated risks.

The comment above was in the context of a more general sense that retail investors expect something from their investment portfolio that they shouldn’t–early retirement, living off dividends, buying a vacation home, etc. If you have enough money, a 5% return will accomplish all of those things for you and more. But for the vast majority of people, a 5% return will not support the lifestyle they would ultimately like to live. However, that statement also wasn’t referring to concentrating risks in a stock market portfolio; it was suggesting that wealth is created in outside industries through the creation of small business and the like.

Of course, you need to make good decisions–and possibly a little luck–when assuming those risks. Not only do you need a comprehensive understanding of the risks involved, but you also need to be certain that risk is mispriced. I like to think that wealth can be created through the stock market–I am not referring to running OPM or the IPO process, either; by concentrating capital where and/or when risk is mispriced.

I have a lot more to this line of thought, but it requires at least several thousand more words. So, I will leave you with this thought: If reward and risk have a direct relationship, but risk is composed of underlying factors as well as perception of those underlying factors*, is there not an opportunity to arbitrage the human error? I am, of course, assuming human error is rampant when it comes to perception and emotion.

I will explain how and why the perception of risk directly contributes to return the next time I post on this subject.

*For instance, a 1% GDP is perceived very differently now than it would have been in 2006.