Getting Along with Risk
Updated: Jun 17, 2022
In the previous post: Why Invest - Many a little makes a mickle, we stressed how even the smallest of Crumbs may end up feeding a family. Now it’s time to introduce another essential concept: Risk
Risks in the world
The world is filled with risks, for example, cancer risks, environmental risks, security risks, etc. As you can see, the word “risk” tends to be associated with adverse outcomes. However, the risk in investments doesn’t necessarily mean adverse outcomes. To understand this, let’s check the graph below.
What is Risk?
"Risk in investments means how returns are dispersed. In other words, higher risk suggests the possibility that your investment can experience both extremely negative and positive outcomes. However, it is known that high-risk investments result in higher returns “on average”. This is thanks to the risk-return relationship.
Risk and return
Imagine the value of your investment declines from the initial value. The only reason you can stand this unpleasant situation is that you expect it to produce higher returns in the future (otherwise, who would willingly invest their money just to lose it?). You can enjoy higher returns in exchange for higher risk (higher uncertainty in investment outcomes).
How much risk you can tolerate to achieve your goal?
So the most important thing is to what extent you can tolerate the risk in order to get the expected investment outcome. Some examples are
“If you earn a high enough salary and don't have any plans to spend that money soon, you can make relatively riskier investments that are expected to bear fruit in the long run, as you have a higher risk tolerance to endure short-term adverse movements (high risk and high return)”
“On the other hand, if you have a plan to spend money in the coming months (for example, tuition fees), you better choose an investment opportunity that is less risky and will surely produce a promised outcome. Of course, the return from such an investment is lower due to the risk-return relationship”
In the next post, we will explain the basic technique to reduce the risk we learned just now.
Risk in investing means how returns are dispersed
Risk-return relationship: Higher (lower) return is associated with higher (lower) risk.
Important to understand risk tolerance and expected investment outcome