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Balancing Risk and Reward in Investing

By Dave

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Risk and Reward in Investing

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Investors have a tendency to focus on the potential rewards of investing, but it’s equally important to think about the risks. Risk is a natural part of investing—there’s no reward without taking some risk. So, investors need to understand how to balance risk and reward when approaching the market.

We’ll explore the types of investing risks you need to know about and compare the relative risk of different assets. We’ll also explain how you can manage your risk and give some examples of how to balance risk and reward in your portfolio.

Risk in Investing

Although the goal of investing is to make money, investors should never forget that they can end up losing money in the process. Anytime you invest, your money is at risk. Even the safest investments carry some risk of losses.

Risk and reward are closely correlated. Any investment with a huge potential reward also carries huge risks. Investments with more modest rewards have more modest risks.

There are no truly low risk, high reward investments—that is, you can’t risk nothing and expect to see your money grow rapidly. However, you can take steps to manage your risk and choose investments with the best return-to-risk ratio.

Risk Factors

There are several different types of risk that investors need to be aware of.

Market Risk

There’s inherent risk in the market in the sense that anything can happen at any time, and it’s completely out of investors’ control. For example, there could be a sudden crash like the “flash crash” in 2010, when the Dow Jones index lost nearly 10% in just over 30 minutes.

While the market has always gone up in the long-term, it has experienced drops along the way.

10 Year Stock Market Chart

Company Risk

Just like things can go haywire in the market without warning, individual companies can also suffer unanticipated setbacks. For example, a website could go down and cut off sales or a company could suffer an industrial accident.

That said, not all companies have the same amount of risk. In general, startups are riskier than blue-chip companies that have been around for 100 years. They may have less resilience in their facilities or workforce, and they can’t absorb setbacks as easily without failing entirely. Alongside this increased risk, investments in startups often have higher potential returns than investments in blue-chip companies.

Allocation Risk

There’s also risk in how investors build their portfolios. A portfolio with just one stock in it is riskier than a portfolio with 100 stocks in it. If that single company suffers a setback, the portfolio with just one stock would sink sharply. Whereas in a diversified portfolio, the loss would be small relative to the overall portfolio.

Liquidity Risk

Liquidity is a measure of how easy it is to buy and sell an asset quickly. Liquidity risk isn’t a major issue in the stock market since buyers and sellers can easily and instantly trade shares for most stocks.

However, liquidity risk can be a major form of risk in other markets. For example, liquidity is very low in the real estate market. If you were to invest heavily in a property, it could be difficult to sell the property quickly when you need cash. It could take months to sell your property, during which time the price could fall or you miss out on other opportunities.

Comparing Risk among Assets

Different types of assets—or subgroups within asset classes—carry different levels of risk and reward.

Individual Stocks vs. ETFs

Investing in individual stocks is considered riskier than investing in ETFs largely because of the difference in allocation risk. When investing in individual stocks, you might have 10-20 stocks in your portfolio. When you invest in an ETF, you might invest in 50-100 stocks. If you invest in 10-20 ETFs, your portfolio may contain hundreds or thousands of different stocks. 

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S&P 500 ETF vs Meta Stock
Meta Stock (META – blue) vs. S&P 500 ETF (SPY – orange)

Growth Stocks vs. Value Stocks

Growth stocks are usually riskier than value stocks because of the types of companies that fall into these two categories.

Many growth stocks represent young companies that often have high debt loads or unproven business models. Moreover, their stock prices are usually predicated on assumptions about what they’ll be worth in the future—and these predictions could be wrong.

Value stocks tend to represent older, more established companies that are trading at a discount relative to their historical prices. They may have strong businesses with little debt and valuable assets. Investments in value stocks are usually driven by financial models. While these aren’t perfect predictors of the future, they’re less speculative than predictions about a company’s future growth.

Netflix vs. Coca Cola
Netflix (NFLX – blue) vs. Coca-Cola (KO – orange)

Speculative Assets vs. Proven Assets

Some assets, like Bitcoin, are more speculative in nature and thus more risky. Cryptocurrencies as an asset class have little price history, so it’s hard to know what they’re really worth or if they’ll be regulated out of existence in the future.

Stocks and real estate, on the other hand, are proven assets that have historically increased in value despite suffering some ups and downs.

Risk Management Principles

We’ll highlight three principles of risk management you can use to balance risk and reward.

Risk Cannot be Avoided

You need to accept the fact that risk is inescapable in investing. Trying to avoid it entirely means avoiding investing at all.

So, it’s important to understand risk and navigate it in a way that works for you. Think carefully about your own risk tolerance and how much you can afford to lose. Everyone’s risk tolerance will be different, so don’t compare yourself to other investors in this regard.

Risk is Partially Within Your Control

To a large extent, you can control how much risk you take on simply by cutting your losses. If you’re not willing to lose 50% of an investment, you can choose to sell if it drops 10% or 20%.

For example, the chart below shows NFLX drop about 70% in a year. It has since rebounded quite a bit and may take out its previous highs in the future. That said, many investors cannot stomach 70% drawbacks in the short-term. If that’s the case, stop losses can be used to cut losing positions before the losses become intolerable.

Always make a plan for how much you’re willing to lose on an investment if it goes against you. Then stick to the plan if the time comes. It’s better to take a small loss and move onto the next investment than to let losses snowball out of control.

Risk Can Be Balanced

You can use techniques to balance your risk and keep it manageable. You can choose which assets to invest in based on their risk and limit how much of your portfolio is invested in high-risk assets. For example, you can choose to invest 90% in stocks and 10% in cryptocurrency instead of investing 50% in stocks and 50% in crypto.

You can also diversify your portfolio to reduce allocation risk. Invest in ETFs to get exposure to a wider range of stocks or invest in other asset classes, such as bonds and real estate..

Example of Risk Management in Practice

Let’s take a look at how you could build a diversified portfolio that spreads your risk over multiple asset classes and reduces your risk.

Broad Market ETFs – 60%

Broad market ETFs, like those that track the S&P 500 or the entire US stock market, give you exposure to a very wide range of stocks. They reduce your risk through diversification.

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You can also invest in ETFs that hold other assets, like bonds, that are considered even safer than stocks. It’s up to you to decide how much of your portfolio to invest in ETFs, but it can be a good idea to invest half or more of your total portfolio across several ETFs.

Individual Stocks – 30%

Individual stocks can represent a moderate risk, moderate reward portion of your portfolio. Invest in companies you like or that you believe will outperform the overall market.

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Remember to balance lower-risk stocks (such as value stocks) with higher-risk stocks (such as growth stocks) when investing in individual companies.

High Risk, High Reward Investments – 10%

You should allocate no more than 10% of your portfolio to high-risk, high-reward investments. These can include investments like cryptocurrencies, artwork, and private businesses.

You should be willing to lose any money you invest in this category of your portfolio. If you have a lower risk tolerance, you may want to skip this portfolio category altogether and invest more in safer asset classes.

Conclusion: Balancing Risk and Reward in Investing

Risk is a natural part of investing and one that you need to think carefully about when making investment decisions. Certain types of assets are more risky than others, so you should build a portfolio that reflects your own risk tolerance. Remember that at the end of the day, you have some control over your investment risk through your approach to investing and by cutting losses early.

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Dave

Dave has been a part-time day trader and swing trader since 2011 when he first became obsessed with the markets. He focuses primarily on technical setups and will hold positions anywhere from a few minutes to a few days. Over his trading career, Dave has tried numerous day trading products, brokers, services, and courses. He continues to test and review new day trading services to this day.

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