Risk and Reward 101
There is a famous quote, variously attributed to U.S. Navy Rear Admiral Grace Murray Hopper or John A. Shedd that says “A ship in harbor is safe, but that is not what ships are built for”
For some, this quote evokes fear or excitement. Others may picture rich rewards or the possibility of hopes dashed on the rocks. We often find ourselves in the position of having to take a chance to obtain some reward or desired outcome. In other situations, we may be exposed to some potential hazard or risk that for which we seek some protection, response, or mitigation. Clearly, our lives are full of risk and reward. An understanding of the interplay between these two ideas can be very beneficial for both our business and personal lives.
When we invest money in CDs, stocks, bonds, or mutual funds we look for a return on this investment. In other words, we want to make our money grow and increase our wealth. Of course, this may not occur to the degree we hope or expect. Indeed, sometimes we may experience negative returns and actually lose money.
Mitigating Risk
The uncertainty of investment returns is an example of risk. Those who want to minimize or avoid this risk entirely might invest in treasury bonds, money market mutual funds or bank CDs. There is a trade-off obviously and these low-risk investments will not offer large returns. This is an example of how a low-risk opportunity is also low reward. It turns out that this is the typical situation and that for one to have a realistic chance of a big financial reward, it is usually necessary to take a larger risk and expose yourself to the chance of a poor return or even a loss.
The level of acceptable risk varies for each of us. It depends on our personal histories, personality, goals, and financial position. Each of us has a different “risk appetite” and strives to find the balance of risk and reward that best suits your particular situation.
Some risk exposures do not really offer an upside and in these cases, we must decide to what extent we will devote our financial resources so as to gain a measure of protection. Common examples include potential damage or threats to our homes, cars, health, and personal items. The more protection (or less “risk”) we desire the more we must usually spend on insurance.
Risk Management
The concept of risk management is mostly about striking a balance between risk and reward or, for those exposures without upside potential, determining what our mental or financial risk tolerance is. Most of us think about risk management when deciding how to invest in our 401(k) or how to choose between stocks or bonds. When looking at options for insurance policies for your home or car, or even umbrella insurance, we should also be applying the idea of risk management.
This type of personal risk management is critical for our financial health, retirement security and protecting what matters to us most in our lives and those of our family. A more detailed introduction to the types of insurance mentioned can be found on www.betterinvesting.org.
Next Steps
For those looking to explore the idea of risk and reward in investments, a good start is the Motley Fool website (fool.com).
