Understanding The Risk And Reward of Investing

The majority of people will find that savings alone will not be enough to afford them a comfortable retirement. For this reason, it is very common for individuals to build themselves an investment portfolio.

Investing is not a sure thing and there are many risks associated with the reward. Let us look at the basics of understanding risk and reward in investing.

Risk/Reward Definition: While most people have a fairly general, intuitive, understanding of the concept of risk it a widely debated topic in academic finance circles. Many do not agree on the exact metric that should be used to define risk. Some argue for things such as Volatility, Sensitivity to market cycles, and other concepts to quantify the idea of risk.

For the average investor, it is sufficient to view risk as how likely it will be to receive a return on one’s investment. Risk is always inversely associated with reward; the higher the risk the higher the reward.

Different Vehicles Different Risks: Many types of investment vehicles exist and they all have different levels of risk associated with them. For example. Bonds are usually considered safe investments, especially bonds from large, successful, corporations and government. The purchaser is guaranteed to receive a return on the investment but the return is usually quite low. Blue Chip stocks and CEDs are another example of low risk, but low reward investment vehicles.

On the other hand, investment vehicles such as venture capital stocks, High Yield (“junk”) bonds, REITs and cryptocurrencies represent options that carry a much higher level of risk but also a much higher potential for returns.

Understanding the risks associated with different types of investment vehicles is necessary if one wants to understand risk and reward in investing.

Industries Associated With Risk: When looking to invest in specific sector investors main options are individual stocks, ETFs, or index funds. Historically, certain industries and sectors have been riskier and with greater volatility, while others have been more reliable.

Biotechnology and Software companies have historically been high risk and high reward industries. For biotechnology, 95% of medical technologies undergoing development will never reach the market. This is especially true for companies developing new drugs and medicines. When a company does have a drug approved the value of the stock usually rises greatly.

Software companies suffer from the same issue. Most programs developed are either never released or do not fare well in the marketplace. For every Microsoft or Oracle, there are thousands of failures.

Examples of lower risk lower reward sectors include Food, Water Services, Energy Utilities, Textiles, and Healthcare. These sectors stay relatively stable, producing growth year over year, but are unlikely to deliver massive returns.

Conclusion: Risk is an inherent aspect of speculative investing and how much risk one is willing to tolerate depends largely upon the investor. Those who are younger are usually much more risk-tolerant, given their greater amount of time to recuperate any loses. Those who are older are likely to be much less risk-tolerant, as they look towards their retirement.

As has been discussed, the risk of a particular investment is determined by several factors, and it is important to assess wisely before deciding to invest.