You probably face risk-reward trade-offs regularly. When you’re running late for an appointment, you might drive fast and aggressively—risking an accident or ticket in exchange for a quicker journey to your destination. Or, you can eliminate the ticket risk by driving lawfully and accepting that your trip will take longer.
The risk-reward trade-off in investing has similar extremes. You can invest aggressively to earn big gains. Or you can pump the brakes and shield yourself from losses, knowing it means lower return potential. The good news is that you have options. With some basic knowledge about investing risk and reward, you can choose a pace that works for you.
Use this guide to deepen your understanding of the risk-reward dynamic in investing and to learn strategies for managing risk so you can reap the rewards comfortably.
Risks Of Investing
Broadly, investing risk is the potential to lose money or make less than you expected on an asset. There are various types of investment risk that describe how underperformance can happen. Novice investors are less concerned with the causes and more concerned with the outcomes, which can include:
- Your 401(k) balance drops by a double-digit percentage, even though you’re invested in the highest-performing funds.
- You buy a stock, or Bitcoin, and it immediately loses value.
- You need to sell stock, but the prices are lower than what you paid.
Rewards Of Investing
The rewards of investing come in various forms, too, such as:
- Capital gains: You have a capital gain when an asset becomes more valuable than when you bought it. If you still own the asset, your gain is unrealized, meaning it’s not taxable or set in stone. An unrealized gain can increase or evaporate at any time. Once you sell the asset for a profit, it is a taxable, realized gain.
- Dividends: Some companies pay dividends, which is a portion of profits distributed to shareholders.
- Interest: Bonds and cash deposits pay interest.
The Risk-Reward Dynamic
In investing, risk and reward are closely linked. Assets with greater return potential often have higher risk and vice versa. Comparing the behavior of AI chip designer Nvidia to a cash savings deposit demonstrates this dynamic in play. Nvidia’s stock price has gained 37.8% in the past year, but was down 36% year-to-date in April. A cash savings deposit earns at most 4% and the balance doesn’t decline unless you withdraw funds.
You have many investing options that demonstrate different levels of the risk-reward trade-off. Here are some popular examples, ranked from low to high risk:
- Cash. Cash balances don’t decline, but deposits earn minimal returns. The highest cash deposit rates currently available are between 3% and 4%. Note that your real returns are often negative, because inflation continually reduces the purchasing power of $1.
- Investment-grade bonds. Investment-grade bonds pay interest and return principal at a set maturity date. The risk of default is low, and the current yield ranges from about 3.5% to 5%. Bond prices can fluctuate, but they are typically far more stable than stock prices.
- Value stocks. Value stocks are companies with predictable profits and relatively low volatility. The S&P 500 Value index returned 7.7% over the last year, including dividends and capital gains.
- Growth stocks. Growth stocks have higher stock prices relative to earnings because investors expect them to grow faster than their peers. They can be volatile, as Nvidia’s history demonstrates. The S&P 500 Growth index returned 22.5% over the past year, including dividends and capital gains.
- International stocks. International stocks can be volatile because they usually have more exposure to political unrest, economic instability and currency fluctuations. The MSCI ACWI ex USA index grew 18.5% over the last year. The index represents 85% of international equities.
- Cryptocurrency. Cryptocurrency is speculative and very volatile. Bitcoin, the most popular digital currency, has gained 93.9% in the last 12 months. Back in 2022, Bitcoin fell 64.3%.
Misconceptions About Risk And Reward
The relationship between risk and reward is not stable or clear-cut. This can prompt some misconceptions about how the risk-reward trade-off should affect your investment decisions. Here’s a look at three misconceptions and how they can lead you astray.
Misconception: High Risk Equals High Reward
High-risk investments can have low reward potential. This is more likely to happen when there is minimal data on the investment, and someone is making big promises about its potential. Penny stocks can fall into this category.
Misconception: Safe Investments Are Better
Risk does not determine whether an investment is better or worse. The safest assets, like cash, don’t earn enough to build measurable wealth. Higher-risk investments, in the right quantities, make it possible for regular people to reach their financial goals.
Misconception: Risk Is Bad
Risk is not bad. It creates opportunity. Without risk, stocks wouldn’t earn more than cash. Investors require higher returns from stocks simply because there is risk involved.
Misconception: You Must Make Bold Moves To Build Wealth
You do not have to gamble to build wealth. You can accept risk strategically and take steps to manage it.
Strategies For Managing Investment Risk
You do not need specialized knowledge or skills to manage your investment risk. Four easy strategies are assessing your own risk tolerance, investing early, investing regularly and practicing diversification.
Know Yourself
Understanding your risk tolerance is essential. If you invest too aggressively, the volatility will be too stressful. You may be compelled to sell your investments in a downturn. This action locks in negative performance and lessens your opportunity to benefit from recovery gains.
Know that every stock market downturn in history thus far has reversed itself eventually. Waiting for that reversal is often the best way to minimize the damage of a downturn.
So, think about what you can handle. Can you stay patient through a 40% decline in your portfolio’s value, or is it more like 15%? At the higher end, you can afford to invest 70% or 80% of your money in stocks. At the low end, a bond-heavy portfolio might be more suitable.
Start Investing Early
Stock prices go up and down in the short term, but the long-term trend is up. Over the last 50 years, the S&P 500 has increased an average of nearly 13% annually, including dividends and before inflation. You can build a lot of wealth with a 13% return.
To be clear, this doesn’t mean an S&P 500 fund will rise every year. Your fund may appreciate this year and fall next year, but those fluctuations will average out positively. The longer you hold that fund without selling, the better your chances of double-digit returns.
Invest Habitually
Timing risk refers to the likelihood of buying an asset just before its value falls dramatically, or selling before it rises. You can minimize the impact of timing mistakes by making smaller, recurring investments on the same day every month or week. With frequent buying activity, your cost to buy those stocks comes from an average of many transactions versus one larger transaction. This minimizes the chances that one mistimed trade will dramatically affect your profit potential.
Combine this practice with a long investing timeline, and you can largely overlook short-term price fluctuations.
Diversify
Diversification is the practice of combining different assets in your portfolio to tailor your risk. As an example, you could invest 50% of your money in bonds and 50% in stocks. Referencing the list above, you can see that this combination provides the stability and income from bonds plus the growth potential of stocks. This approach will be far less risky than a stock-only portfolio.
Investing Rewards Await
In investing, risk creates opportunity. If your financial plan demands you earn more than the 3% or 4%—and it should—now’s the time to get comfortable with risk and how to manage it. Bigger returns are waiting for you beyond that cash savings account. Go get them and watch your financial strength grow.