Tuesday, May 10, 2011

Risk Versus Reward

With any asset, there is always a trade off between risk and reward.  Often times, it feels like you are trying to walk a tightrope balancing the two of them.  First of all, let's define risk and reward.

Risk is the variance in possible outcomes.  For example, a stock that may shoot up from $10 to $20 one day and then drop down to $5 the next day is much riskier than a stock that stays at $8 over the span of a certain time period.  Or you can think of lottery tickets as being extremely risky while coupons are not.  With lottery tickets, your winnings can vary from $0 to $1,000,000+ and with a coupon, you know for certain what you are getting for certain.

Reward is pretty obvious.  In most cases, it either is or can be exchanged into money (for comparison purposes).  It is what we seek to gain from certain actions.  When you think about investing your savings, you are seeking the highest return possible (or highest growth in your assets) which is your reward.

So what is the relationship between risk and reward?  They are usually positively correlated: as you find something that gives a higher reward, it usually carries a higher risk.  The simplest example is stocks versus bonds.  There are some stocks that can increase 300% over the course of a year while others drop 90%.  Bonds, on the other hand, earn you maybe 1-3% for certain over the course of some specified time frame.

So what combination is right for you?  You should probably take a risk tolerance test online (or I might just post one up on this blog later on) to see what risk profiles you should be looking at.  Generally, younger students should take on a riskier portfolio that a retiring senior since young adults don't have to worry too much about short term fluctuations.  It also depends on how well you handle emotions and stress.  Would you be able to sit through losing half of your money on the possibility of doubling it?

As you'll see in the next post, stocks in general have the most potential and have proven to be consistently the most rewarding in the long run.  For the ambitious who want to make the most of their money, they will probably want to have an aggressive portfolio of mostly stocks, but I'll talk more about asset allocation later as well.  You should think about what time horizon you are looking to keep your money invested and find the right risk tolerance level before choosing a specific allocation.  I'll continue to give more examples as we continue discussing risk management and stocks and bonds.

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