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Understanding Risk and Reward in Investing Thumbnail

Understanding Risk and Reward in Investing

All investments involve some degree of risk. In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision.

Regardless of the type of investment, there will always be some risk involved. You must weigh the potential reward against the risk to decide if it's worth putting your money on the line. Understanding the relationship between risk and reward is a crucial piece in building your investment philosophy.

What is Risk?

When you invest, you make choices about what to do with your financial assets. In short, risk is the possibility that a negative financial outcome might occur.

For example, your investment value might rise or fall because of market conditions. Corporate decisions can affect the value of your investments. If you own an international investment, events within that country can affect your investment.

There are other types of risk. How easy or hard it is to cash out of an investment when you need to is called liquidity risk. Another risk factor is tied to how many or how few investments you hold. Generally speaking, the more financial eggs you have in one basket, say all your money in a single stock, the greater risk you take.

The level of risk associated with a particular investment or asset typically correlates with the level of return the investment might achieve. The rationale behind this relationship is that investors willing to take on risky investments and potentially lose money should be rewarded for their risk.

Reward is the possibility of higher returns. Historically, stocks have enjoyed the most robust average annual returns over the long term, followed by corporate bonds, Treasury bonds and cash equivalents such as short-term Treasury bills.

The Different Investment Risk Profiles

There are three main investments readily available to investors: stocks, bonds, and mutual funds. Each has its own risk profile and some carry more risk than others. Understanding the differences can help you more effectively diversify and protect your portfolio.

Stocks

Most people have stocks in their investment portfolio, and for a good reason. According to Ibbotson Associates, stocks have reliably returned an average rate of 10% annually since 1926. This is higher than the return you're likely to get from many other investments. However, be cautious with stocks. You could buy stock in established, blue-chip companies that have a fairly stable stock price, pay out dividends, and are considered relatively safe. If you choose to invest in smaller companies, such as startups or penny-stock firms, your returns are much more volatile.

Bonds

A popular way to offset some risk from investing in stocks is to keep some money invested in bonds. When you purchase bonds, you're essentially lending money to a corporation, municipality, or other government entity. Bonds are generally safer and receive a rating from agencies such as Moody's, Standard & Poor's, and Fitch. Ratings act like a report card, and AAA-rated bonds are considered the safest.

Government bonds come with a guarantee that you'll get your money back plus interest. At the other extreme are junk bonds, which are sold by corporations. Junk bonds promise much higher returns than long-term government bonds, but they're high-risk, and in some cases not even considered investment-grade securities.

Mutual Funds

Mutual funds make sense for many investors because they're managed by professional portfolio managers. This means you don't need to worry about watching the market or monitoring a stock portfolio.

Mutual funds work like a basket of stocks or bonds, and when you buy shares of a mutual fund, you get the benefit of the variety of assets held within the fund.

You can choose from a wide variety of funds with different risk profiles. Some hold large-company stocks; some blend large- and small-company stocks; some hold bonds; some hold gold and other precious metals; some hold shares in foreign corporations; and just about any other asset type that comes to mind. While mutual funds don't completely take away risk, you can use them to hedge against risk from other investments.

Common Investment Risks

Losing Money

The most common type of risk is that your investment will lose money. You can make investments that guarantee you won’t lose money, but will give up the opportunity to earn a decent return. For example, U.S. Treasury bonds and bills are backed by the government, which makes them the safest in the world. However, when you calculate the effects of inflation and the taxes you pay on the earnings, your investment may return very little in real growth.

Falling Short of Your Financial Goals

Whether you achieve your investment goals depends on the amount invested, length of time invested, rate of return or growth, fees, taxes, and inflation. If you can’t accept much risk in your investments, then you will earn a lower return. To compensate, you must increase the amount and the length of time invested.

Managing Risk

In the financial world, risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management occurs when an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment, such as a moral hazard, and then takes the appropriate action (or inaction) given the fund's investment objectives and risk tolerance.

You cannot eliminate investment risk. But two basic investment strategies can help manage both systemic and non-systemic risk.

  • Asset Allocation. By including different asset classes in your portfolio, you increase the probability that some of your investments will provide satisfactory returns even if others are flat or losing value. 
  • Diversification. When you diversify, you divide the money you've allocated to a particular asset class, such as stocks, among various categories of investments that belong to that asset class. Diversification, with its emphasis on variety, allows you to spread your assets around.
  • Hedging (buying a security to offset a potential loss on another investment) and insurance can provide additional ways to manage risk. However, both strategies typically add to the costs of your investment, which eats away any returns. In addition, hedging typically involves speculative, higher risk activity such as short selling (buying or selling securities you do not own) or investing in illiquid securities.

Many investors find that a modest amount of risk in their portfolio is an acceptable way to increase the potential of achieving their financial goals. By diversifying their portfolio with investments of various degrees of risk, these investors hope to take advantage of a rising market and protect themselves from dramatic losses in a down market.

How much volatility an investor should accept depends entirely on the individual investor's tolerance for risk. One of the most commonly used risk metrics is standard deviation, a statistical measure of dispersion around a central tendency. You look at the average return of an investment and then find its average standard deviation over the same time period. Normal distributions dictate that the expected return of the investment is likely to be one standard deviation from the average 67% of the time and two standard deviations from the average deviation 95% of the time. This helps investors evaluate risk numerically. If they believe that they can tolerate the risk, financially and emotionally, they invest.

Understand Your Risk Tolerance

All investors must find their comfort level with risk and construct an investment strategy around that level. A portfolio that carries a significant degree of risk may have the potential for outstanding returns, but it may also cause you to lose your life savings. When determining what you want to invest your money in, consider the appropriate asset allocation for your age, risk tolerance, and time horizon.

Young investors can afford higher risk than older investors because they have more time to recover if the market declines. If you are five years away from retirement, you probably don’t want to take extraordinary risks because you will have little time left to recover from a significant loss. On the other hand, being too conservative may mean you don’t achieve your financial goals.

The bottom line is all investments carry some degree of risk. By better understanding the nature of risk, you’ll be better prepared to meet your financial goals. Learn more about risk and investing by talking to an expert at Daly & Associates today. We want you to become more confident with your money and would be happy to discuss your goals.

Investing involves risk.  Loss, including loss of principal may occur. No investment strategy can guarantee positive results, nor can it protect against loss in periods of declining markets. Past performance does not guarantee future results. Mutual funds are sold by prospectus only. Before investing, investors should carefully consider the investment objectives, risks, charges and expenses of a mutual fund. The fund prospectus provides this and other important information. Please contact your representative or the Company to obtain a prospectus. Please read the prospectus carefully before investing or sending money. In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.  Bonds are also subject to other types of risks such as call, credit, liquidity, interest rate, and general market risks.

                                   
               
             
               
             
               
             
                             
             
             
                             


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