Understanding risk should be one of the first concepts any new investor learns. It helps outline portfolios and entire companies are based around reducing risk for investors. The inability for the human mind to rest easy while your hard earned money is invested in the volatile stock market gave rise to the idea of risk and the constant venture to reduce it.
What is risk?
Having money or assets in any form brings inherent risk. If you save your money under your pillow at night your house could burn down and you could lose it all. If you’re invested in a company’s stock, the company could go under and you could get little to nothing back. If you buy and sell futures, you have an undefined amount of risk based on a lot of factors. Essentially risk is the chance that you could lose some or all of an investment.
Most, if not all, assets have an approximate amount of risk that is widely known. Cash is extremely safe. Barring the fact that you keep your cash under your pillow, cash has very little chance of becoming worthless or losing massive amounts of value.
Bonds are a pretty safe option, but their rate of returns fluctuate with the market and the interest rates the Fed establishes. It’s hard to lose value in bonds. Stocks, on the other hand, are affected by lot’s of external factors in the market and swing up and down daily. A company can have a market cap of 50 billion one day, and lose half their value the next day just because of an article.
Risk vs. Reward
Why would you invest in stocks or futures if cash is safer? Cash makes little to no return, and therefor you won’t make any money on your investment in cash. The opposite is true for stocks. Your investment in an IPO could skyrocket and multiply your earnings 100 fold.
Using the same example of an IPO, the company could go under as well and you could lose all of your money. That’s the risk vs reward model. For the most part the more risk you undertake the higher the rewards can be.
Business owners and entrepreneurs undertake a massive amount of risk because a lot of their personal funds and their livelihood is invested into a business. If the company goes under, they lose everything. All of their investments are gone, and depending on how the company is structured, the owner could be liable for the debts the company incurred.
Risk in your life
Risk can be assessed and numerically stated many different ways, but a good beginning stance to take would be based around age and excess income. Age is the major factor in most assessments of risk because the amount of time left to recoup losses or collect gains impacts many peoples lives.
Young investors should find it comforting that we have a distinct advantage over older generations. We have much longer to accumulate profits and we recover losses much easier without having to worry about retirement. If you read the article Diversification you can get a good grip around the concept of a growth portfolio and why young investors benefit from high growth investments.
Older investors have a much tougher situation when it comes to assessing risk. Retirement, supporting your children, and paying mortgages all weigh on your minds, and that can cause added stress you don’t need. Saving for retirement and keeping the current nest egg you have is essential for keeping your blood pressure low. Assuming less risk, and exposing yourself to less and less equity will ensure that you retire safely. Once again, sample portfolios are outlined for retiree’s in Diversification.
My site CollegeInvestr.com covers topics ranging from basic budgeting to market research and commentary. My main focus is to provide information for young investors trying to build wealth and reduce student loans. If you’ve liked this article, come check out more of my material!
David's main goal is to provide finance and investing education to young college students looking to pay off student loan debt and increase wealth.
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