Investing

Investing: The Concept of Risk and Return

There are many different ways a person can invest and many different possible attitudes to have towards the practice. One concept that is discussed fairly widely and is very helpful in maximizing your success with investing is that of risk and return. In simple terms, the return you get on an investment is a percentage of your first investment, which comes back as a profit. In this context, risk refers to the fact that there is a chance that your investments will not produce a return.

Often, it is posited that the relationship between risk and reward or return in an investing context is direct. In this sense, the higher the potential risk, the higher the potential reward. Conversely, if one makes a very safe decision and opts to invest in something very low-risk, then there is also likely much less potential for reward. Which decision is best to make depends on the investor themselves, as different people have different investment habits and different levels of tolerance for risk, especially when it comes to their finances being at stake.

In general, when you invest, you want to try and find the best possible balance between the risks that you are taking and the reward you are hopefully going to get out of it. Some potential investments carry great potential for reward, but the risk is too large to make it worthwhile. This is the very basis of the idea of risk vs reward in an investment context, but it is important to understand that there are many different takes on the idea, and they are supported to different degrees. Our article goes into the concept in more depth and also explains some of the ways in which you can analyze both potential risks and rewards in a potential investment.

What Are Some of the Different Types of Risks in Investment?

The types of risks that a person can encounter when investing can be broken down into different categories. Generally speaking, they are going to be risks that are specific to a certain industry or project or risks that are related in some way to relevant competition, markets, or risk on an international level.

It is also important to note that there are different ways that risk can present itself to the investor. Individual assets are often riskier than other types of assets because they are potentially able to be voided. If a company goes into liquidation, then the shares that it has sold may become worthless, potentially instantly. This obviously makes them riskier to invest in, as there is less security for the investor if such a thing does end up happening. The same can also happen with government bonds if a country was somehow to cease existing or experience extreme political turmoil. It sounds far-fetched, but nothing is impossible.

Another form of risk in investing is that the returns that your investments generate are too small to keep up with the inflation that is being experienced. In this instance, you still receive a return on your investment, but because it has not kept up with inflation, the money itself is actually worth less than the money you initially had and then invested. Some assets also require fees to be paid, so this can be a risk in and of itself too. If you pay exceptionally high fees for a particular asset and then receive only modest returns, you lose money even if you have a positive return on the investment.

How Can Risk Be Minimized When Investing?

While it varies depending on the type of investment you are intending to make, there are some steps you can generally make to minimize the risk associated with your investments. However, these need to be balanced with your desired rewards, and it is also worth noting that they are obviously not entirely foolproof. It is also worth mentioning that if you put too much emphasis on minimizing risk, you may end up limiting your returns too. For example, a common way to try to minimize risk in investing is by diversifying your portfolio. This prevents you from being too dependent on a particular sector or asset class. However, you only have a finite amount to invest in assets, and if you choose to spread it very thinly, you can miss out on great returns if a particular sector performs especially well.

With the above being said, diversification of one’s portfolio is probably still the most reliable way to ensure your portfolio against risk that is specific to sectors or asset classes or to your returns in general.

How Should We Perceive the Risk-Reward Relationship?

Generally, when people talk about risk and return in investing, they refer to the concept as being a tradeoff. That is to say, that both are almost always found together and directly impact each other. It is perhaps best to approach each investment with a consideration of both the risks and rewards associated. There are also a number of factors that it is recommended that you consider before you make a potential investment, especially if it is going to be particularly high-risk. These include how likely you are going to be able to replace any funds that you may lose in the return of an unsuccessful investment, for example.

Another is how close you likely are to retirement. If you are relatively close to retirement age, then it may not be wise to make very risky choices in investing, as you are not going to have as much time to replace any funds that you might lose before you retire with less time left to work. Conversely, you most likely have far more money saved up than you would as a younger person, so it may actually be lower-risk in a sense for you to go into a investment with a higher potential for loss, as a substantial loss may not be as damaging to you financially as it would to a person who is less established.

It is also good to look at portfolios on the whole through the lens of the risk-reward relationship. Experienced investors, or those who know a great deal about investing and the market, are generally able to judge fairly easily the level of risk and reward that a certain portfolio will have with it. When doing so, the assessment can focus on the diversity that the portfolio presents or whether or not the holdings are riskier than they should be, or instead are safer and therefore do not maximize their potential for reward.

The risks that a certain portfolio may present can also be seen in the context of the portfolio as a whole. For example, a certain investment may be very risky, but if the rest of the portfolio is based on lower-risk holdings, then in that context, it may not be so extreme. In this sense, if the investor in question has a strong basis in investing over the long term and slowly building up their wealth or using investments to supplement their income, then it can be considered less risky for them to decide to invest in an especially high-risk asset, as they have a greater financial stability than others who invest over the shorter term and rely more on short-term or swing trading.

Some Specific Examples

There are several types of investments that can almost always be considered as offering both high risk and return. Some examples of these would be penny stocks or ETFs. If you are thinking about going into investing in these, then the best bet would once again be to do so in the context of a strong and diverse portfolio so you can minimize the risk you might encounter with these.

On the level of the portfolio, a portfolio that is comprised largely of equities is going to present you both with higher potential for risk and reward than others may. Another way of doing this is solidifying your position in one sector that represents a substantial amount of holdings in it. In order to further increase both the risk and reward that a portfolio presents, then you might choose for example to focus more of your investing into one particular sector.

In this sense, it is clear that many investors will deliberately go into riskier investments, as they know that there is a direct relationship between risk and reward in many cases and that, the higher the risk, the higher the reward is likely to be in a successful investment. There are also different asset classes in investment, and some of them are considered to be inherently riskier or safer than others, though this obviously depends somewhat on what is happening in the world at the time and if there are any other factors that are affecting the asset class itself.

For example, investing in property is considered on the whole to be a medium-risk prospect. There are many ways to mitigate the risk associated with investing in property, though. If you invest in properties by actually buying and selling on properties, then a good way to make this less risky is by having the properties inspected and renovated professionally. This ensures that you have as little trouble as possible selling them on and getting a return on your investment.

Shares are often considered to be high-risk, but this is obviously quite a sweeping statement, and in reality, the risk associated with a particular share depends a lot on the company itself, as well as the share you are going to buy. It is much less risky to buy a share from a company that is large and stable than it is to buy a share with a start-up, for example. However, if you are lucky, a share bought from a start-up may have incredible returns. This is why it is so important to consider the relationship between the risk and the reward for every potential investment you go into.

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