The idea of risk vs reward is a cornerstone of financial literacy and personal finance. 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 an investment’s potential for loss and the potential for return.
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 invested in low-risk investment grade mutual funds or a bond fund the probability of success is very high but the payoff is very low. So, the risk/reward for investment grade bonds 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 and different risk factors to consider when evaluating an investment strategy.
Market risk is the risk that your investment will lose value because of broad market conditions and market declines. For example, if the stock market crashes, then the value of your investment will crash and you will make less money.
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 mutual funds and bonds, but less volatile than cryptocurrency.
Volatility can be a good or a bad thing, depending on the time frame you are looking at. If you plan to hold an investment for a long time, then volatility can be a good thing because you will have more investing opportunities over time when the market fluctuates. If you are looking to cash out in a few months or a few years, then volatility can be a bad thing because your investment can lose value during that time.
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 that goes up by 10%. That’s great! But if you could have invested in Bitcoin instead, and it went up by 50%, then practically you lost 40% by not investing in Bitcoin. This is opportunity cost.
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, ie. How much risk you are willing to take and whether you are willing to lose money.
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 risk are you willing to take?
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? Many investors use the following strategies:
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.
Hedging is another financial concept that can help you reduce your risk. Hedging is the idea that if you’re worried about an investment dropping in value, you can “hedge” that investment by making another investment that will do well if the first investment drops in value.
For example, if you’re a farmer you might grow two different crops, one that does well in wet weather and one that does well in dry weather. This way, if one crop fails, the other crop will likely still provide a good amount of income.
In financial markets, hedging is similar. For instance, if you’re investing in an asset that does well in periods of low inflation, you might also invest in an asset that does well in periods of high inflation. This way if the first investment drops in value, you can offset that loss with gains from the second investment.
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.
Read more about dollar cost averaging.
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 common target allocation of 60% stocks, 30% bonds, and 10% Bitcoin. If Bitcoin does really well, your portfolio might turn into 55% Bitcoin, 30% stocks, and 15% bonds. If you want to maintain the 60/30/10 ratio, you can sell off some Bitcoin and use the proceeds to buy more stocks and bonds.
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.
The key to managing risk is to know how to identify risks and to have a plan for how you’ll deal with them. If you have a plan in place, you can take a risk-tolerant approach to investing and take advantage of the large opportunities that come from certain types of risk.
Frequently Asked Questions:
What is risk vs reward?
Risk is the potential for loss, and reward is the potential for gain. Typically, the more risk you take, the more you stand to gain. However, you also stand to lose more if you fail. In investing, risk typically refers to the volatility of a security or portfolio over time. A risky portfolio will typically have a larger potential for gain or loss.
What is risk-adjusted return?
In finance, the term "risk-adjusted return" refers to the return on an investment adjusted for the risk taken on by the investor in making the investment. The idea is that risky investments should not be weighted equally to non-risky investments if the risky investment has a greater potential for loss.
What is a “high-risk, high-reward” investment?
A high-risk, high-reward investment is one that carries a high potential for gain, but also carries a high risk of loss.
Are riskier investments more profitable?
Not necessarily. Many investors prefer lower-risk investments because they can be more certain of their potential return.
What is diversification?
Diversification is the practice of investing your money in different types of assets to lower your overall risk. For example, if you invest in just one stock, you’re putting all your eggs in one basket. Diversifying means that you’re spreading your money across different investments so that you’re not relying on any single investment for your income.
What is the highest risk investment?
It depends on what you mean by “highest risk.” If you mean “the investment with the highest potential for gain,” then you might think of highly volatile assets like Bitcoin or other cryptocurrencies. If you mean “the investment with the highest potential for loss,” then you might think of an investment in a company that’s about to go bankrupt, which is even higher risk.
What is the lowest risk investment?
A low risk investment is one that has a small potential for loss. This might be a large and stable company with a long track record of paying dividends, or it might be a savings account with a bank or other cash equivalents.