Risk vs. Reward
The idea of risk versus reward is a cornerstone of financial literacy. It’s the idea that we can make a tradeoff between the likelihood of success and the potential for payoff.
So, how do you determine the risk/reward of your investment? Well, you need to think about the probability of success and the potential payoff.
For example, consider a lottery ticket. The probability of winning is very small, but the payoff is very large. So, the risk/reward for a lottery ticket is high risk and high reward.
Conversely, if you invest in a low-risk bond fund, the probability of success is very high, but the payoff is very low. So, the risk/reward for a bond fund is low risk and low reward.
Types of Risk
In terms of investing, risk is the likelihood that you will lose money on an investment.
There are different types of risk to consider when evaluating an investment.
Market risk is the risk that your investment will lose value because of broad market conditions. For example, if the stock market crashes, then the value of your investment will likely crash as well.
Unsystematic risk is the risk that your investment will lose value because of factors specific to it. For example, the price of a stock can be affected by a company-specific issue, such as a scandal or a product recall.
Volatility refers to the amount of fluctuation in an investment’s value over time.
Investments that tend to be more volatile tend to be riskier because their value changes more over time.
For example, stocks are more volatile than bonds. So, stocks are riskier than bonds. Cryptocurrency even moreso.
Risk is not just the chance of losing money. Risk is also the chance of not making as much money as you could have made.
Opportunity cost is the idea that if you make a decision, you’re giving up all of the other options you didn’t choose. So, when you choose to invest in one asset, you’re giving up the opportunity to invest in another asset.
For example, let’s say you invest in a stock, but it ends up losing money. You could have invested in a different stock, but you didn’t. So, you’re paying the opportunity cost of the lost money.
The risk/reward tradeoff is important to keep in mind, but it’s not the only thing you need to consider. You also need to think about your personal risk tolerance.
Your risk tolerance is based on a few factors: your appetite for risk, your ability to handle losses, and your desire to maximize your gains. In order to determine your risk tolerance, you need to consider a few different questions:
- Do you have an appetite for risk?
- Can you financially handle losing some of your investment?
- Is it important to you to maximize your gain?
If so, you might be interested in investing in something that’s more risky.
Alternatively, if you’re risk averse, you might not want to invest in something that could result in a significant loss. Take a look at your overall financial plan and ask yourself:
- How much money do you have to invest?
- How much money can you afford to lose?
- How much are you willing to risk?
If you don’t have a lot of money to lose, there are investments you can make that have a lower risk.
Risk mitigation is the process of reducing your risk. So, what can you do to mitigate your risk?
In finance, diversification is the idea that spreading your money across multiple investments will reduce your risk. As a simple example, let’s say you have $1,000 to invest. You could put all of your money into one stock, and if that stock does poorly, you have nothing left.
Alternatively, you could put your money into five different stocks. If one of those stocks does poorly, you still have $800 left over. If you're lucky, the value increase of the remaining stocks has made up for the loss of the one.
Diversification is a way to reduce your risk. The more diversified your investment portfolio is, the less risk you will have.
Another way to reduce your risk is to hedge. For example, if you’re a farmer, you might grow two different crops. This way, if one crop fails, the other crop will likely provide a good amount of income.
In financial markets, hedging is similar. For instance, if you’re investing in a stock that’s volatile, you might want to “hedge” that risk by investing in another stock that is less volatile.
Dollar cost averaging
Dollar cost averaging (DCA) is the process of investing a set amount of money into an investment. You do this at regular intervals, regardless of what the price is. Over time, this allows you to buy more shares when the price is low and fewer shares when the price is high. Dollar cost averaging is a good strategy to choose if you are unsure what a particular asset will do in the short term.
Finally, you might want to consider periodically rebalancing your portfolio. Rebalancing is the act of selling off parts of your portfolio to get back to your target allocation. For example, let’s say you have a target allocation of 60% stocks and 40% bonds. However, if the stock market has done really well, your portfolio might be at 80% stocks and only 20% bonds. Rebalancing your portfolio will help you get back to 60/40.
Risk is a big part of investing. However, it’s important to remember that risk isn’t always a bad thing. In fact, risk is often thought of as an opportunity for large profits.