The Basics of Risk vs. Reward and How to Manage It

For newcomers to the market, there’s one term that will be seen quite often, and while just about everyone thinks they understand it, it’s vitally important that they actually do understand it. That factor is risk vs. reward.

What Is Risk Vs. Reward

Risk vs. reward as a term in and of itself is pretty self explanatory. Essentially, it is a term that reminds investors to consider the risks of investments made, compare those risks to the potential rewards associated with those investments, and make an educated decision based on this knowledge.

Where Risk Comes From In The Market

To property assess the risks associated with, and the potential rewards that could come as a result of, an investment, it’s important to understand where risk comes from when making investments. Ultimately, there are several factors that are can lead to risk in the market:

  • Asset Choice – At the end of the day, investors can invest in just about anything in the market. However, historically, the market has shown that some assets come with a higher level of risk than others. For instance, gold, considered to be a safe haven investment, is generally a low risk asset, along with bonds, some currencies, and several other assets. On the other hand, equities, along with other, more volatile assets, tend to be viewed as higher risk assets.
  • Investing/Trading Strategy – Another factor at play in the risk you take on when investing has to do with the strategy, or strategies that you employ. Some strategies are designed to bring minimal risk, generally resulting in minimal rewards. On the other hand, some strategies, known for creating some of the highest profit margins just so happen to be some of the highest risk strategies.
  • Market ConditionsMarket conditions also play a crucial role in risk. In fact, market conditions can change the levels of risk associated with various different types of investments. For example, gold is generally considered to be a low risk asset. However, when global economies are booming and global markets break into bullish territory, the risk of loss associated with investing in gold can become ever present.

Sources Of Reward In The Market

A reward in the market is clocked any time a profit is generated. When first getting started in the market, you may think that these gains are only generated from increasing values in stocks and other assets. However, that’s not necessarily the case. In fact, there are several ways in which an investment can become profitable:

  • Increase Asset Valuation – Of course, this is a give in. If you buy a stock, a bar of gold, or any other asset for that matter, at a low price, and sell it at a higher price, you’ve made a profit.
  • Dividends – Some investments can come with what is known as dividends. Dividends are payments that are generally made to investors who hold shares in companies with dividend payments. In most cases, dividend amounts are predetermined and paid based on the amount of shares held. Dividends can be so lucrative that there is a specific style of investing known as dividend investing that has proven to be a great avenue for many.
  • Interest Payments – Some investments come with a predetermined interest rate that the investor will be paid throughout the life of the investment. A great example of this would be the CD, or certificate of deposit. When purchasing a certificate of deposit, the amount of time the money will be tied up in the investment is predetermined along with the interest rate, and the overall return on the investment.

Managing Risk & Reward

While you will find various articles online that base the entire concept of managing risk vs. reward on asset allocation based on age, this isn’t always the best way to go. Sure, investing more in stocks and less in bonds when young and moving higher portions of your portfolio to lower risk investments as you age is a good concept, but managing risk and reward also has a lot to do with personal goals and appetite for risk. Therefore, there’s no true one size fits all solution to managing risk and reward, but here are a few pointers:

  • Always Remember That Aggression Can Cost You – Any time we invest, we want to make as much money as possible in a short period of time. However, one of the first steps to properly managing risk and reward is simply being aware that they both exist. A savvy investor will always keep it in the back of their minds that risk is always present, and when there is a larger potential reward, chances are that risk will be greater as well.
  • Us A Risk/Reward Ratio When Making Decisions – One of the best ways to quantify risk vs. reward is to turn it into a ratio. While this will take some practice, and the best ratio to use will largely depend on the strategies you employ, the assets you invest in, and your personal goals, it is well worth taking the time to break down a good risk/reward ratio based on your investing goals and/or trading habits. Investopedia’s resource on risk vs. reward ratio is a must read if you’re not sure how it works.
  • Trading Strategy – You can also manage risk through the use of different trading strategies. At the end of the day, some strategies will be riskier than others. By diversifying not only your asset allocation, but your trading strategy, it’s possible to further balance risk vs. reward.

The Key Takeaway

The key takeaway here is that while investing is an important part of preparing for the future, it’s also important to not only understand, but manage the risks associated with the action. By properly managing risk vs. reward, savvy investors ensure that they never take too big of a loss, even on their worst day.

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