One of the keys to successful investing is to properly associate the risk of an investment with the potential reward. An investment that, at its best, will deliver small profits should not be especially risky. More likely, an investment that may have a big payoff will require that the investor risk his entire initial investment.
The expression “you can’t get blood from a turnip,” author unknown, here refers to the fact that an investment won’t provide a reward if there is no risk taken on by the investor. There is no free lunch.
Risk in Buying Lottery Tickets
To examine the highest potential risk/reward scenarios, consider how the lottery works. Gamblers can buy a $1 dollar ticket and entertain the chance to win millions, or even hundreds of millions of dollars. This works because the odds of winning are very small, and the gambler will lose his entire stake if he doesn’t have the correct number.
Investments Without Risk
At the alternate end of the spectrum is a certificate of deposit, or government bond. Investors buying these have virtually no risk, but the return is also very low. In the current environment, short term CDs pay almost nothing Investors can get higher rates for longer terms, but the risk increases with time.
Even if the investor is likely to have his interest paid and principal returned, he does take on the risk that by tying up his money, he may miss out on the opportunity to invest at higher rates.
Choosing the Proper Risk Reward Ratio
Most investments fit into the middle ground in between no risk and an all-or-nothing situation. For a frequently traded stock, there is usually the opportunity to invest with the intention of making a profit while understanding that there will be the chance to sell the stock and still retain most of the principal even if the investment go awry.
For example, an investor may look at a $50 stock’s history and determine that there is a reasonable chance the stock may either go up in price by $5 or go down by $5. He is balancing his assumed risk of a $5 loss against his assumed reward of $5.
It makes little sense to invest in a stock that may increase $1, but has the risk that it may drop $10. The opposite effect leads people to speculate in penny stocks, hoping they will grow from pennies to dollars. This kind of thinking tends to ignore the impact of the odds, or fact that it is more likely that the stock will fall to nothing rather than explode to the upside.
The best investment would be one where there is an equal chance the investment will gain more than it loses; ideally, something that has an equal chance that it will go up $5 or go down $2. As another opposite example, covered calls generally have a limited upside, but a poor performance can lead to large losses.
Investors need to balance their thinking between risky investments with little chance of payoff versus turnips with no chance of reward. A diversified portfolio of investments in many different asset classes gives the best of chance of hitting the proper risk/reward ratio.
Sources:
Phrases.org.uk
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