Core Principles Series - Principle #6 - "The balance of risk and reward"

Core Principles Series – Principle #6 – “The balance of risk and reward”

Core Principles Series – Principle #6
“The balance of risk and reward”

In any investment there is risk. A person might argue that “well that isn’t true for an envelope of cash that I have at home” but even that is subject to theft, misplacement, or at a minimum a loss of 1% to 2% a year based on inflation. The key point of this principle however is that there is always a relationship between risk and reward. The greater the reward – the higher the risk.

In the graphic related to this post, you’ll see three example returns. The bottom line is conservative, the top line is open market and aggressive. You’ll note that the general trend is up in all of them but the amount of ‘ups and downs’ or volatility in the example increases with the level of reward.

This is true of all investments. The higher the reward, the higher the risk. If there is low risk, then the reward will be low also. If at any time someone tells you that this isn’t true for their investment – that somehow they have magically created great reward with very little risk – then something is wrong.

Also note that risk comes in many forms. A common risk not normally considered is ‘opportunity risk’. This kind of risk means that ‘if I do this, then I can’t do that’. A good simple example is a savings deposit at the bank. In a general savings account I can move money in and out as I wish but the interest rate is very low – generally less than a 1/2 percent.

If I put that money in a CD (certificate of deposit) then I can get perhaps 2% return but I can’t touch my money for a year (until the CD expires). That’s opportunity risk. Higher reward but my risk is that I lose access to my money for a period of time.

There is always a balance between risk and reward.

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As a reminder, the 10 principles of smart investing are: