Risk versus Reward: Understanding the Tradeoff
In this section, you’ll…
- Understand the trade-off between risk and reward
- Learn how to measure a stock’s risk factor
- Learn about some real-life examples of risk in the stock market
There is a certain degree of risk in all aspects of life – the stock market is no different. The market’s normal degree of volatility will produce both positive and negative returns for investors over the course of time.
Just look at the chart below of various types of investment classes, and you’ll see the immediate trade-off between potential reward and the risk you have to take.
You can actually determine how risky an individual stock or investment is by knowing its beta – the measurement used to quantify an investment’s volatility (or risk) relative to a performance benchmark. The performance benchmark is typically the index of the exchange it trades on.
Generally, the higher a stock’s beta, the more risky it is. A stock with a beta of 1.0 is considered relatively stable, as a beta of 1.0 means the stock’s price would increase or decrease 10% every time the S&P 500 increased or decreased 10% – or in other words, it would move in line with the market.
By definition, there are high-beta stocks and low-beta stocks. An example of a high-beta stock would be a stock with a beta of 2.0, meaning it’s price would increase or decrease by 20% each time the S&P 500 gained or lost 10%. Conversely, an example of a low-beta stock would be a stock with a beta of 0.5, meaning it’s price would increase or decrease only 5% if the S&P 500 index gained or lost 10%.
Market risk refers to the possibility of an investing ‘downdraft’ taking stock prices collectively lower. Risk and reward go hand in hand. If you want higher returns from your investments, you have to assume a proportionate amount of risk. You can increase wealth through guaranteed investments. But to grow your wealth after factoring in the cost of living, you need to take on risk. Putting your money in a bank is saving, not investing. You also take on unnecessary risk as you expose those savings to the ravages of inflation.
Shake, Rattle and Roll: Real Life Examples Of Risk In The Stock Market
Some stocks simply sizzle. These money-making stars shoot up like rockets unencumbered by normal laws such as gravity.
Others seem all too aware of the earth’s pull. These dogs resemble nothing so much as large boulders being dropped off a cliff.
There’s no doubt about it – investing in individual stocks means there’s a possibility of ending up with a seat on one of these two types of stock market runaway trains. That’s great if you buy a stock that’s charging upwards. But if you invest in a stock that’s spiraling downwards, it can be a harrowing, never-to-be forgotten ride.
“Try to be greedy when others are fearful, and fearful when others are greedy.” – Warren Buffet
Invest With Your Head, Not Your Heart
Here’s one phrase you’ve probably heard a lot these days, “invest in things you understand”. There always seems to be another instant millionaire story hitting the headlines about some seven-year-old who bagged a bundle by, say, putting all his money into the company that makes his favorite action figures.
“If there’s one thing kids know it’s toys”, goes the usual commentary. “Buy the stocks of companies you’re familiar with and that make products you use and enjoy, and you won’t go wrong,” is the message.
Great slogan, but it’s wrong.
Say you like Coke, and you buy the stock. Who says it will perform better than Pepsi’s stock, which your best friend invested in because he or she prefers Pepsi?
90 percent of investors, professionals and amateurs alike, simply don’t do enough homework. When it comes to investing, never let your heart rule over your head. Save that for love.
Protecting Yourself From Stocks That Fall
Stocks that fall dramatically in price can hit you right in the pocketbook.
It also raises an important question: How can you avoid the Fresh Choices and Laser Eye Centers of the investing world? And how can you protect yourself from dumping your money into a market leader like Microsoft only to see half your investment vaporized in a matter of months?
It’s actually not as difficult as you might think. Coming up later in Module Four, we’re going to review two effective risk management strategies to help you weather even the worst of stock market storms.
“I never attempt to make money in the stock market. I buy on the assumption the market could close tomorrow and not open for five years.” – Warren Buffet
Key Learning Points
- It’s impossible to accurately predict which stocks will outperform the market or by how much. Some soar unexpectedly while others plummet without a moment’s notice.
- Risk is defined as the financial uncertainty that the actual return on an investment will be less than the expected return.
- There is a direct relationship between risk and return, meaning the greater the risk of an investment the greater the potential for return.
- An investment’s risk level can be determined by its beta – the measurement used to quantify an investment’s volatility relative to a performance benchmark. Generally, the higher a stock’s beta, the more risky it is.