Investors tend to focus on the potential rewards of investing, but it is equally important to consider the risks. Risk is a natural part of investing, there is no reward without risk. Therefore, investors need to understand how to balance risk and reward when approaching the market.
We'll explore the types of investment risks you need to know about and compare the relative risks of different assets. We'll also explain how you can manage your risk and provide some examples of how to balance risk and reward in your investment portfolio.
Risk in investment
Although the goal of investing is to make money, investors should never forget that they may end up losing money in the process. Anytime you invest, your money is at risk. Even the safest investments carry some risk of loss.
Risk and reward are closely related. Any investment with a high potential return also carries significant risk. Investments with more modest rewards involve more modest risks.
There are no truly low-risk, high-reward investments, that is, you can't risk anything and expect to see your money grow quickly. However, you can take steps to manage your risks and choose investments with the best return-to-risk ratio.
There are several different types of risks that investors should be aware of.
There is inherent risk in the market, meaning anything can happen at any time, and it is completely out of investors' control. For example, there could be a flash crash like the “flash crash” of 2010, when the Dow lost nearly 10% in just over 30 minutes.
Although the market has always been rising over the long term, it has seen declines along the way.
Just as things can go wrong in the market without warning, individual companies can also suffer unexpected setbacks. For example, a website could crash and stop sales or a company could suffer an industrial accident.
However, not all companies have the same amount of risk. In general, startups are riskier than larger companies that have been around for 100 years. They may have less flexibility in their facilities or workforce, and cannot easily absorb setbacks without complete failure. Besides these increased risks, investments in startups often have higher potential returns than investments in larger companies.
There is also risk in how investors build their portfolios. A portfolio containing only one stock is considered riskier than a portfolio containing 100 stocks. If that single company suffered a setback, a portfolio containing just one stock would sink sharply. While in a diversified portfolio, the loss will be small compared to the overall portfolio.
Liquidity is a measure of how easy it is to quickly buy and sell assets. Liquidity risk is not a major issue in the stock market as buyers and sellers can trade shares easily and instantly for most stocks.
However, liquidity risk can be a major form of risk in other markets. For example, liquidity is very low in the real estate market. If you are going to invest heavily in a property, it may be difficult to sell the property quickly when you need the money. It may take months to sell your property, during which time the price may drop or you may miss out on other opportunities.
Compare risks between assets
Different types of assets – or subgroups within asset classes – carry different levels of risk and reward.
Individual stocks versus ETFs
Investing in individual stocks is riskier than investing in ETFs largely because of the difference in risk allocation. When investing in individual stocks, you may have 10-20 stocks in your portfolio. When you invest in an ETF, you might invest in 50-100 stocks. If you invest in 10 to 20 ETFs, your portfolio may contain hundreds or thousands of different stocks.
Growth stocks versus value stocks
Growth stocks are usually riskier than value stocks because of the types of companies that fall into these two categories.
Many growth stocks represent young companies that often have high debt loads or unproven business models. Furthermore, their stock prices are usually based on assumptions about what their value will be in the future, and these predictions may be wrong.
Value stocks tend to represent older, more established companies that trade at a discount to their historical prices. They may have a strong business with little debt and valuable assets. Investments in value stocks are usually driven by financial models. While these are not perfect predictions for the future, they are less speculative than predictions about a company's future growth.
Speculative assets versus certain assets
Some assets, such as Bitcoin, are more speculative in nature and therefore riskier. Cryptocurrencies as an asset class have little price history, so it is difficult to know their true value or whether they will be regulated and removed from existence in the future.
On the other hand, stocks and real estate are proven assets that have historically increased in value despite experiencing some ups and downs.
Risk management principles
We'll highlight three risk management principles you can use to balance risk and reward.
Risks cannot be avoided
You have to accept the fact that risk is inevitable in investing. Trying to avoid it completely means avoiding investing at all.
Therefore, it is important that you understand the risks and deal with them in a way that suits you. Think carefully about your risk tolerance and how much you can afford to lose. Risk tolerance will be different for everyone, so don't compare yourself to other investors in this regard.
The risks are partly within your control
To a large extent, you can control the amount of risk you take simply by minimizing your losses. If you are not willing to lose 50% of your investment, you can choose to sell if it drops by 10% or 20%.
For example, the chart below shows NFLX falling about 70% over one year. It has since rebounded slightly and may surpass its previous highs in the future. However, many investors cannot afford a 70% drawback in the short term. If so, stop losses can be used to cut losing positions before losses become unbearable.
Always make a plan for how much you are willing to lose on an investment if it goes against you. Then stick to the plan if the time comes. It is better to take a small loss and move on to the next investment than to let losses get out of control.
Risks can be balanced
You can use techniques to balance your risks and keep them under control. You can choose which assets to invest in based on their risk and decide how much to invest your portfolio in higher-risk assets. For example, you could choose to invest 90% in stocks and 10% in cryptocurrencies instead of investing 50% in stocks and 50% in cryptocurrencies.
You can also diversify your portfolio to reduce allocation risk. Invest in ETFs to gain exposure to a wide range of stocks or invest in other asset classes, such as bonds and real estate.
An example of risk management in practice
Let's take a look at how to create a diversified portfolio that spreads your risks over multiple asset classes and reduces risk.
Broad Market ETFs – 60%
Broad market ETFs, such as those that track the S&P 500 or the entire U.S. stock market, give you exposure to a very broad range of stocks. They reduce your risk through diversification.
You can also invest in ETFs that contain other assets, such as bonds, which are considered safer than stocks. It is up to you to decide how much of your portfolio you want to invest in ETFs, but it may be a good idea to invest half or more of your total portfolio across multiple ETFs.
Individual shares – 30%
Individual stocks can represent a moderate risk and moderate reward portion of your portfolio. Invest in companies that you like or that you think will outperform the overall market.
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Remember to balance low-risk stocks (such as value stocks) with high-risk stocks (such as growth stocks) when investing in individual companies.
High-risk, high-reward investments – 10%
You should allocate no more than 10% of your investment portfolio to high-risk, high-return investments. These can include investments such as cryptocurrencies, artwork, and private companies.
You should be prepared to lose any money you invest in this category of your portfolio. If you have a lower risk tolerance, you may want to skip this portfolio category altogether and invest more in safer asset classes.
Conclusion: Balancing risk and reward in investing
Risk is a normal part of investing and you should consider it carefully when making investment decisions. Certain types of assets are riskier than others, so you should create a portfolio that reflects your risk tolerance. Remember that ultimately, you have some control over your investment risk through your approach to investing and cutting your losses early.