Risk and reward
Risk and potential reward are directly linked in investing: assets with the potential for higher returns almost always come with a higher chance of losing money too, and safer assets almost always offer lower long-run returns. There's no reliable way to get stock-market-level returns with savings-account-level safety, if something promises that, it's either misleading you or hiding the real risk somewhere.
A worked example
A government bond might offer a steady, near-guaranteed 4% a year. A diversified stock index might average 7-10% a year over the long run, but in any given year could be down 20% or up 30%. A single small, speculative company might occasionally double in a year, but could just as easily fall 80%. Higher potential reward consistently comes paired with higher potential loss.
Key takeaways
- There is no genuine "high return, no risk" investment, if it sounds like one, be skeptical.
- Your personal risk tolerance (how much loss you can handle, financially and emotionally) should shape what you invest in.
- Diversification doesn't eliminate risk, but it reduces the damage any single bad outcome can do.
Common mistakes
- Chasing the highest possible return without considering how much you could lose.
- Panicking and selling everything during a normal, expected downturn.
- Putting money you can't afford to lose into the riskiest available option.
Test yourself
1. What's generally true about assets offering very high potential returns?
- They are always guaranteed safe
- They usually come with higher risk of loss too
- They never lose money
- They are illegal
Answer: They usually come with higher risk of loss too. Higher potential reward and higher potential risk are directly linked, one rarely comes without the other.
2. What should shape how much risk you take on?
- What your friends are doing
- Your own financial situation and ability to handle potential losses
- The stock's ticker symbol
- Nothing, always take maximum risk
Answer: Your own financial situation and ability to handle potential losses. Personal risk tolerance and financial circumstances should guide how much risk is appropriate for you specifically.
3. Does diversification eliminate investment risk entirely?
- Yes, completely
- No, but it reduces the damage any single bad outcome can cause
- Diversification increases risk
- Diversification is illegal
Answer: No, but it reduces the damage any single bad outcome can cause. Diversification spreads risk around so no single failure sinks the whole portfolio, but it doesn't remove risk altogether.
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Sources and further reading
- Investor.gov (U.S. SEC): Introduction to Investing
- Investor.gov: Glossary of investing terms
- FINRA: Investing basics for individuals