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
- 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 attorney –higher 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 months –Lower 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 child –lower 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 years –lower 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 child –higher 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
