Investment risk vs reward: what's your attitude?
In this article, we’ll explore risk vs reward and help you determine your ideal investment type.
Investments are all about the risk and return relationship (and the way you feel about risk).
Stock and bond markets are volatile and subject to change at any time, but they aren’t the only investment option for the more risk-averse.
You need to know how much risk you're willing to take before you can build a successful, diversified investment portfolio.
An SEC-regulated, fiduciary financial advisor can help you navigate the risks and rewards of investing and put your interests first.
Understanding risk versus reward
You might be wondering, “Which form of investment has the most amount of risk involved?”
The answer is stock and bond investments. Usually, the risk rises with the reward level (though there are some high reward options at medium risk levels, too).
To calculate an investment's relative risk and reward, you need to figure out the risk/reward ratio.
Put simply, the risk/reward ratio measures the prospective reward an investor can earn for every dollar that they spend on an investment against the level of financial risk attached to the investment.
Here’s the calculation:
THE AMOUNT A PERSON COULD LOSE IF THE ASSET CRASHES / THE AMOUNT OF PROFIT THEY CAN EXPECT TO HAVE EARNED BY THE TIME THE STOCK OR BOND PERIOD CLOSES
Figures are then presented as a ratio, and this ratio helps investors to determine if individual high-reward investments are worth the risk.
For example, a risk/reward ratio of 1:5 shows that an investor stands to earn $5 for every $1 that they invest and potentially lose.
It’s generally advised that any ratio above 1:3 is appropriate for investment, but some go for much riskier stakes.
The type of investment you should make depends on your approach to money and how much you’re willing to risk for a higher possible investment reward.
If you need help making investment decisions, your best starting point is to speak with a financial advisor. They can point you in the right direction and create an investment plan that works for you. Connect with a financial advisor here.
What level of investment risk is right for you?
You’ll need to know what kind of investor you are before you can really commit to building a successful, diversified portfolio of assets.
Many people aren’t totally aware of their financial attitudes, including their thoughts on risk and reward, and then they suddenly come to a point where they need to decide, but they don’t know where to start.
Getting on the property ladder is a good example. Imagine you’re trying to buy a house. You’ve got enough money to put a deposit down, but the house you’re buying needs a lot of work and renovation to become the dream home you’ve imagined. You also need to replace your car. You can only really afford two of the three things listed above without incurring more debt.
A. Choose all three options and deal with the consequences later?
B. Choose all three options but pay for the car in installments, knowing that interest will increase the final amount you’ve paid after three or four years?
C. Choose the first two options, opting not to replace the car until you’ve purchased the home and finished renovations?
There’s not necessarily a wrong answer here. But there is the answer you would truthfully select.
Your choice should help you to confirm whether your approach to money is high-risk, medium-risk or low-risk.
In turn, that will confirm what kind of investments you should consider making.
There are no absolute rules when investing (beyond things like insider trading and ethics laws, of course), but having knowledge of financial matters and doing due diligence is essential.
More affluent people are more likely to be high-risk investors, but no investment or investor is 100% safe, as we find out during market crashes.
If you’re still on the fence, consider another scenario more directly tied to investing. You have found an investment, and you’ve calculated its risk/reward ratio as 1:2.
This means you could earn double what you could lose. It’s a high-risk, volatile stock investment.
There are no absolute rules when investing, but having knowledge of financial matters and doing due diligence is essential
What are my investment risk and reward options?
When we break things down based on the risk-return relationship, we can see that there are three investment options at different levels of risk.
Each option covers different asset types and situations, and whether you’re willing to gamble or be far more conservative with your savings, there’s an investment opportunity for you.
Here are the three options:
High-risk, high-reward stocks — These are the best option for high-risk investors. Usually, they have either a significant chance of loss or underperformance or a high chance of devastating loss. Crypto assets, mini-bonds and VC (venture capital) are examples. The rewards are potentially huge, but the likelihood of a bad outcome must be considered.
Medium-risk, high-reward stocks — These are the best options for more careful investors, and they can be hard to find, especially in financially tumultuous times. There aren’t many medium-risk opportunities with high rewards currently available, but real estate can be a good option. Real estate investments combine stability with a high profit ceiling.
Low-risk, high-reward stocks — No investments can be made without any risk at all, but some are safer long-term bets than others. Government and corporate bonds are less likely to crash and offer decent interest rates. Currently, ten-year high-quality bonds provide rates of 4.78 per cent. Money Market Mutual Funds are also incredibly secure and flexible.
Get expert investment advice
Due to the volatility of the investment market, it’s always worth getting expert financial advice before you make any decisions.
History is full of examples of high-risk investments that didn’t work out and high-risk investments that did.
Independent financial advisors will help you navigate the risks and rewards of investing and put your interests first. Answer a few simple questions and find an SEC-regulated, fiduciary financial advisor and take charge of your investment portfolio. Get started now.
Kate has written for leading publications and blue chip companies over the last 20 years.