Grasping the concept of investment risk is essential for upholding a fitting long-term investment tactic. Risk can be, and indeed should be, construed in various ways. For some people, risk implies the chance of attaining a return that exceeds their expectations. In contrast, for others, it could denote the possibility of monetary loss, inability to match the cost of living, or failure to hit a specific objective. The common factor among these interpretations is they all pertain to uncertainty.
Investment inherently carries some level of risk. Alpha West Founder Joshua Westerman believes that a higher risk corresponds to a higher potential gain and a higher possibility of loss. Identifying the correct position on the risk-reward scale often poses a challenge. Then, tailor a portfolio to match that position.
What Is the Risk/Reward Ratio?
Josh Westerman defines the risk/reward ratio as the potential gain an investor could achieve for every dollar they put at risk on an investment. Many investors employ this ratio to evaluate the projected returns of an asset against the degree of risk they need to accept to obtain these returns. A risk/return ratio that is lower is frequently more desirable since it indicates lesser risk for a comparable potential profit.
How Does Risk Relate to Reward in Investment?
A fundamental correlation between risk and reward exists that all investors should understand. Investments with lower risk generally yield lower returns. As the risk scale increases, the potential for higher returns also increases.
Expert Joshua Westerman believes that patience is crucial. The stock market is volatile, implying potential decreases in investment value in the short term, possibly significantly. However, the stock market’s fluctuations typically balance out over an extended period, potentially offering higher returns for the assumed investment risk.
The correlation between investment risk and reward is a bit different. Returns from investments with similar risk levels can vary. Yet, this correlation is generally valid and provides a valuable investment perspective.
When the possibility of investing in a higher-risk asset arises, it’s essential to determine if it offers potentially more significant returns that make the increased risk worthwhile.
What are the Potential Risks Associated with Investing?
While contemplating risk in general, specific risks in an investment portfolio might also be worth considering. Joshua Westerman identifies some of the most common potential risks to look out for when investing.
- Stock-specific risk is associated with a specific company going under or underperforming. This can occur even if the broader market is doing well. Diversification can help mitigate stock-specific risk.
- Inflation risk pertains to inflation diminishing returns. Any held financial asset comes with inflation risk, but some are riskier than others. For example, cash is considered a safe asset because capital return is almost guaranteed. However, lower interest-based returns typically carry a higher inflation risk.
- Market risk refers to the overall risk taken by investing. It’s the potential for losses due to the performance of the entire market rather than just particular segments.
- Liquidity risk is being unable to withdraw an investment or convert it into cash when desired. Liquidity risk varies among assets. For instance, selling S&P 500 exchange-traded shares is typically easier than property of sale, where the market isn’t as liquid. Such assets are, therefore, said to carry a higher liquidity risk.
The risk-reward ratio quantifies the potential gain versus potential loss associated with an investment or project. A higher risk-reward ratio is usually more appealing, implying a substantial return on investment without unnecessary risk. If the ratio is excessively high, it may signal that the investment carries too much risk. On the other hand, a meager ratio could raise doubts. When deciding on a suitable ratio for their portfolio, investors should consider their ability to bear risk and their investment objectives.