I once had a co-worker who always liked to say, “getting out of bed in the morning is a risk.” This was his way of saying that the concept of zero risk does not exist. So it goes with investing. Taking a position in any investment vehicle becomes a game of risk and return in every instance.
Hence, we as investors engage in a game of risk management. This involves assessing the risk of each investment and measuring that against a potential return.
If one can properly mitigate such perils, they can succeed in a risk-filled environment, and possibly turn it to one’s advantage.
Understanding Risk and Return
So how does one come to terms with risk management? According to the CFA Institute,
“[E]ffective risk management identifies, assesses, and controls numerous sources of risk in an effort to maintain an appropriate balance between the expected rewards and potentially negative outcomes associated with risks incurred.”
This does not involve seeking the absolute minimum risk in every asset. While FDIC insurance makes bank deposits below a threshold close to zero risk, one also struggles to earn more than a 1% return.
Even if one turns to a municipal or corporate bond, we can point to a Stockton, California or a Lehman Brothers that declared bankruptcy. Hence, we should not seek to avoid all possible perils.
Nor should we seek the highest returns without regard to risk. Many investors became temporarily wealthy before losing everything in the dot-com bubble in the early 2000s.
More recently, we saw this in the cannabis industry as stockholders bid Tilray (NASDAQ:TLRY) to a $20 billion market cap as its peak despite projected revenues of only $41 million for the year. Such hubris easily leads to massive losses.
Assessing Risk Management
Hence, successful investing means finding the proper balance. Finding such equity involves assessing time, risk tolerance, diversification, and investment knowledge.
Time plays a critical factor, especially with retirement investing. Most advisors encourage younger investors to take more risk. In this case, potential rewards become higher, and the recovery from losses becomes easier. Older investors cannot recover so easily and should take fewer risks.
Also, comfort levels with risk vary with investors. For those willing to take a chance on “losing it all” in their quest for wealth, they can take a small percentage of their assets and buy riskier stocks. However, those that do not want to take such risks should not do so. They can still earn returns in more stable stocks.
Such investors mitigate risk through diversification. This means spreading one’s assets among different stocks and other vehicles to limit potential losses.
Although some will perform better than others, it also means seeing a stock fall into bankruptcy will hurt an investor to a much lesser degree.
Also, assessing risk and return means evaluating one’s investment knowledge. Investors such as Warren Buffett have leveraged their expertise to tremendous advantage.
Indeed, the more one knows, the better they can assess both risk and return. At the other extreme, many who need to invest in retirement do not want to take a personal interest in investing. Fortunately, these passive investors also enjoy a great deal of choice when it comes to investing vehicles.
More passive investors handle this by buying a mutual fund or ETF which varies investments between multiple stocks and bonds. One favorite example involves buying the SPDR S&P 500 ETF (NYSEARCA:SPY).
This invests in S&P 500 stocks. S&P stocks have to meet a series of size, trading, earnings, and other criteria. Also, if a Lehman-like bankruptcy occurs, investors see only a minimal impact since that amounts to only one of 500 stocks.
Despite the risks, investors earn an average long-term return of about 10% in SPY. Another popular vehicle for passive investors involves target-date funds. These funds change stock and bond allocations based on the number of years before retirement takes place.
A more active investor will take a similar approach, albeit with fewer investments. This could involve keeping a certain percentage of assets in bonds and cash. Concerning stock assets, it could mean positions in safer stocks such as Johnson & Johnson (NYSE:JNJ) or Microsoft (NASDAQ:MSFT).
Also, if one’s risk tolerance permits, they might put some percentage in a penny stock or a startup. Either way, active investors effectively run their own mutual fund or ETF. As such, an honest assessment of risk and return remains critical to their success.
The Bottom Line on Risk and Return
Understand risk and return allows investors to not only succeed in an environment of uncertainty, but also turn such conditions to their advantage.
The low yields of savings accounts and most bonds necessitate some level of stock investing. Succeeding in stocks involves an understanding of time, risk tolerance, diversification, and investment knowledge.
Fortunately, investment vehicles exist to fit the needs and comfort level of most investors. By taking an honest assessment of risk and return, investors can not only earn profits, they can also manage both the fear and potential for loss that comes with investing. Given that knowledge, now is the time to get out of bed.
As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter at @HealyWriting.