PERSONAL INVESTING: Learn The Basics - Risk, Reward and Volatility

Optimize your personal investment strategy. Master the basics of investing, portfolios, financial planning, stocks, bonds & much more!

Let's start with THE BASICS OF INVESTING.

Here, you are going to learn the basics of investing, from compounding to stocks, bonds, and more.

Below are some of the topics we will be treating on this page. 

  • What an investment is
  • The long-term nature of most investments
  • The relationship between risk and reward
  • How risk can be measured by volatility


A topic that is close to the heart of many people is money and below are common ways that people make money

  • 1.  earning it by working a job –That is what most people do.
  • 2.  inheriting it from a family member –if you happen to have rich uncle
  • 3.  investing their own money –that’s the focus of this write-up

Let's think more about investing. What is it?

In very simplistic terms, INVESTING is the process of using your own money to make more money.

For example, upon the birth of a baby, grandparents or other relatives often open a savings account or buy a savings bond for the child.

This is a type of investing because the money in the account earns even more money.

When people invest, they typically have goals, like paying their living expenses in retirement, sending their children to college, buying a new home, or leaving a gift to others at death.

But bhat is a common feature of these goals? 

  • The tend to be far in the future. 
  • They require a lot of money.

Do people typically use investing as a strategy to pay for groceries? For gasoline? For dinner and a movie? 

The answer to the above questions is "No". Most people have jobs to pay for these kinds of expenses and employ investing to plan for large expenses in the future.

In investing, there is a relationship between an investment's risk and its reward: Reward is the amount of money you can earn, while Risk is the chance that an investment's actual return will be different than what's expected, including the possibility of losing some or all of the original investment.

Reward (or return) is what you receive from what you invested while Risk is also measured in volatility (the ups and downs of an investment's value). We'll look more at volatility a bit later.

The above graph shows the relationship between reward and risk. Point A represents low risk and low reward. It is like a savings account at the bank—very low risk, but also very low reward or return.

Point D represents high risk and high reward. This represents an activity such as starting a new business. There is potential for high return, but also a great risk of losing some or all of your money.

Using the same axes, but this time without a line, think about what each of the indicated points on the graph above represents.

Because the reward is greater but the risk is the same, Point B is preferable to Point C.

Using the same graph, match the relative points on the graph with their correct reward/risk characteristics.

  • ·        Point A has the same reward and less risk compared to Point E
  • ·        Point D has less reward and less risk compared to Point E
  • ·        Point B has more reward and less risk compared to Point D

When comparing investments, the portion of the graph which would be the most preferable to investors is the Point A. Investors choose to get the most reward while taking on the least amount of risk. That's what this portion of the graph represents.

Another way to think about risk is through the volatility (the ups and downs) of an investment's value.

In the graph below, the pink line represents the value of an investment over time, e.g., a child's college education fund. The green line represents the amount needed for the investment's goal—the estimated cost of college.

As with the above graph, the green line represents the amount of money needed to pay for college and the pink line is the value of a child's college education fund over time. At which points on the graph would parents feel confident about their ability to pay for college? 

You must have guess right. All points above the green line  gives parents the confidence about the ability to pay for college.  The value of the investment is more than the cost of college; volatility is helping in this case.

Volatility is not necessarily a bad thing; it's just a feature of most investments.

Problems with volatility arise when the value of an investment is lower than the goal when the money is needed. The span of time until the money is needed from an investment is called the time horizon

If you think you need $15,000 for college expenses and you only have $10,000—that's a problem.

A long time horizon allows for higher risk investments (investments with a higher volatility), as there is time to recover from any downturns.

A short time horizon may not have sufficient recovery time, so it is wise to minimize risk.

Which balance of risk and reward would be appropriate for each of the following investments?

  • 1.  the 401(k) retirement account for a 25-year-old attorneyhigher risk / higher reward (Absolutely! With 40 years to go, there's enough time to accept more risk to earn more reward.)
  • 2.  the down payment on a home you want to purchase in the next six monthsLower risk / lower reward (You wouldn't want to lose money that you needed in a relatively short period of time. Put it in a savings account!)
  • 3.  a college account for your 17-year-old childlower risk / lower reward (With college starting in just a year, it's best to reduce risk.)
  • 4.  living expenses in retirement that is planned to start in two yearslower risk (As you move closer to the goal, it makes sense to lower risk—resulting in a lower reward.)
  • 5.  a college account for your 17-year-old childhigher risk (If you have 18 years before the money is needed, you will probably have more money at the end if you choose a higher risk/higher reward investment.)

In summary:

Investing means using money to make more money

Risk is the potential to lose some or all of the investment

Reward is what you receive from your investment

Volatility is risk measured by the ups/downs in value

Time horizon is when the money from an investment is needed

 

Next, we talk about the best time to start investing and how compounding impacts on returns over time. Click HERE to continue...

 

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