Risk and reward is one of the most misunderstood topics in all of personal finance and investing. Most people just think of the “reward” portion of the equation. But like any equation, there are two sides to it that must equal each other. Let me explain the relationship that risk and reward have with each other when it comes to investing. Let’s go!
In most of life, there is a tradeoff with the amount of risk that one takes to get something and the amount of reward that they will get for taking that risk. It’s a relationship that is seen in all aspects of our lives. Let’s look at a few non-financial examples.
In 1901 Annie Edson Taylor became the first person to ever go over Niagara Falls in a barrel and survive.
The risk: Her life.
The potential reward: The fame of being the first person to go over Niagara Falls in a barrel.
The actual result: The fame of being the first person to go over Niagara Falls in a barrel.
When Michael Dell was in college at the University of Texas, he sank all of his money into his business that later became Dell Computers.
The risk: All of his money, his reputation, and his time.
The potential reward: Dell Computers becoming what it is today.
The actual result: Dell Computers becoming what it is today.
Thomas Edison is arguably the greatest inventor of all time. But to get to that point in his life there was much risk.
The risk: His money, reputation, the time it took him to learn the science of his inventions.
The potential reward: The lightbulb, motion picture, power generation, etc.
The actual reward: The lightbulb, motion picture, power generation, etc.
Even though these are great stories, it is important to remember that when you take a big risk, there is the POTENTIAL for a big reward. That means that there is also the POTENTIAL for a big loss. Here are a few non-financial examples.
In 1988 Boobie Miles was considered one of the best high school football players in the state of Texas. He was recruited by dozens of colleges and had multiple scholarship offers. However, with an early season knee injury he opted to forgo surgery to repair it and after reinjuring his ACL, never achieved the same success in football as before.
The risk: Not having knee surgery.
The POTENTIAL reward: Getting a football scholarship and going to college with the potential of playing at the professional level.
The actual reward: All scholarship offers were revoked, his highschool career ended, he never had the opportunity to play at the professional level.
Similar to Annie Edson Taylor, Charles Stephens attempted to go over Niagara Falls in 1920. However he was found dead inside of his barrall at the bottom of the falls.
The risk: His life.
The POTENTIALreward: The fame of going over the falls in a barrel.
The actual reward: Death.
In life there is always a balance to be struck between risk and reward. If you are going to take a HUGE risk, there needs to be the potential for a HUGE reward.
(1) Mo’ Risk, Mo’ (Potential) Reward
The same is true for your money. Let’s look at some different examples of where you can put your money and how much risk you will take with it and how much of a potential reward that you will get for that risk.
For the rest of this article, let’s measure both risk and reward on a scale of 1-100.
1= Basically no risk
100= A ton of risk
(The numbers are for demonstration purposes only.)
What happens if you put your money in a savings account at your local bank? Not much actually. If you have $1,000 and you put it in a savings account, after a year you will probably have something like $1,000.05. That’s it. You made a nickel. Congratulations…
But the trade off with putting your money in a savings account at your bank is that you will have virtually no risk. Even if your bank becomes insolvent, you will still get your $1,000 through the FDIC insurance that your rbank had.
So putting your money in a savings account is not risky at all but also there is no potential for a reward either.
Savings Account:
Risk: 1
Potential Reward: 1
How about if you buy a CD (Certificate of Deposit)? Once again you will probably get a really low interest rate. Something like 0.60% . That means that you would have made $0.60 after a year if you invested $1,000. Congratulations…
But once again, the trade off is that there is very little risk that you could lose your money. There is more risk than just putting it in a savings account, but still very little risk.
1-Year CD:
Risk: 3
Potential Reward: 3
What if you aren’t happy with a measly 0.60% interest rate and wanted more? So you decide to invest in a really big company that has a long track record and is really stable. The chances of this company going out of business and you losing your money are very small. However, there is more of a chance of you losing your money than with a CD. (Think of companies like Walmart, General Electric, P&G, Coca Cola, etc.)
Big Giant Company Investment:
Risk: 16
Potential Reward: 9-21
Say that is still not enough for you though. You want the potential for bigger returns and interest. So you decide to invest in a small company that is in the tech field and has a very short track record and is in its infancy. You want to earn a higher return than the boring large, old, established companies so you decide to invest your money with a smaller, more risky company. Remember, you have the chance of losing all of your money because the company went bankrupt (a reward of 1). But you also have the chance that you could be investing in the next Facebook, Apple, or Microsoft on the ground floor (a reward much higher).
Small Dynamic Company Investment:
Risk: 29
Potential Reward: 1-56
Okay. Let’s say that all of the previous investments are still not enough. You want a BIGGER return (hopefully). You decide to invest in a small cryptocurrency that not many people know about yet. If you have done this, you have wandered into the world of speculation. I will have another article that I will go into more detail on at a later day. With investing in the cryptocurrency, you are speculating that it will go up in value. However, there is a pretty decent chance that you will lose all of your money.
Small Unheard of Cryptocurrency:
Risk: 48
Potential Reward: 1-86
Now let’s say that you still don’t like any of those options and you want to risk the MAXIMUM that you can. So you decide to buy lottery tickets. You spend all of your money on lottery tickets in hopes that you will hit the jackpot of $900 million! Woo hoo! But you and I both know that there is a really high chance that you will lose ALL of your money.
Lottery Tickets:
Risk: 100
Potential Reward:1-100
I really hope that these illustrations make sense. There are, of course, thousands of other investments that you can choose from. And within each of those categories, there are probably thousands of individual investment choices. Each of those investments has a level of risk and a level of potential reward with it.
(2) Mo’ Risk, No Reward???
I hope you see the pattern of the investment options above. You want to have AT least the level of reward for the level of risk associated with that reward.
In other words, if you take a bigger risk, you should expect a higher potential reward.
If you invest in something that has a risk of 20, you should expect to get back a reward of at least 20.
Will it always happen? No. Sometimes companies go bankrupt and mistakes can be made. It happens. But over time, your amount of risk and reward should basically be the same (or better).
Think about it. You wouldn’t take an investment risk of 45 if you knew your reward would be the same as a CD (a reward of 3) would you? Of course not! Because the reward is not worth the risk you have to take to get it!
But what if you could find an investment that was the opposite? What if you could find an investment that would give you a reward of 45 but you only have to take a risk of 3? That sounds great! But unfortunately, those simply do not exist.
If someone ever tells you that they can get you HUGE returns on your money for NO risk tell them to take a hike. They are either doing something illegal, lying to you, or just don’t know what they are talking about. Opportunities like this are called arbitrage opportunities and they rarely make themselves known. People WAY smarter than me have built algorithms that look for the smallest amounts of arbitrage 24/7. There is simply no way you or I will just stumble upon one. Sorry to burst your bubble.
Final Thoughts
The topic of risk and reward is one that most people have not mastered. There are formulas and calculations that can be made to better quantify how much risk and reward that you should have but they are outside the scope of this article.
There are ways that you can mitigate your risk as well. You can use things like mutual funds, index funds, ETFs, and all around diversification.
Just know that:
- If you take a little risk, you will get a little reward.
- If you take a big risk you have the potential for a big reward but the potential to lose a lot also.
- You should not take a big risk for a little reward.
- If you are told that you can have a BIG reward for a SMALL risk it is probably not true.
Most people will have several different types of investments. Each of those investments will carry a different amount of risk. That means that you might have some of your portfolio with a risk of 5 or 10, another portion of your portfolio might have a risk of 30, and another part of your portfolio might have a risk of 60, and so on.
This is how most people structure their investments. This includes me. I have some of my portfolio in really safe investments, some in moderately risky investments, some in small companies, some cryptocurrency, etc.
I hope that this has enlightened you to this topic. We have honestly only scratched the surface of it. However, most people don’t even understand it to this extent.
If there are other articles that you would like me to write, please leave them in the comments!
And as always, please share this article with a friend!
Until next time!
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