The investment risk versus reward equation is a fundamental concept in investing that relates the amount of potential profit to the amount of potential loss. Understanding and properly balancing risk and reward is key to building wealth through investing. This equation states that assets with higher risk tend to have higher potential returns. Conversely, safer investments typically have lower returns. Using the risk versus reward equation, investors aim to maximize returns for a given level of risk, or minimize risk for a target return. There are several ways investors can balance risk and reward when constructing a portfolio, such as diversification and asset allocation.
Higher Risk Investments Offer Potentially Higher Returns
The risk versus reward equation illustrates that investors demand greater potential returns for taking on higher risk. For example, stocks have delivered around 10% annual returns over the long run but with significant volatility and potential for loss. On the other hand, bonds and cash equivalents like savings accounts offer minimal growth potential but with less volatility. This principle applies to various asset classes – real estate, private equity, venture capital, etc. Understanding this tradeoff allows investors to choose assets aligned with their risk tolerance and return objectives.
Diversification Spreads Out Risk
A key technique investors utilize is diversification across various uncorrelated assets. For instance, a portfolio splitting investment funds between stocks and bonds will likely see lower volatility versus allocating solely to equities. Losses in one asset class may be offset by gains in another. Diversification allows investors to improve their risk versus reward profile. Investors can also diversify within asset classes, such as owning stocks across different sectors, market caps, geographies, etc. The appropriate level of diversification depends on an investor’s goals and risk appetite.
Asset Allocation Balances Risk And Reward
Asset allocation refers to the overall mix of asset classes in a portfolio, based on the investor’s time horizon, goals and risk tolerance. It relates to the relative weighting between higher risk/higher return assets like equities versus lower risk/lower return fixed income. As an example, a 30-year old investor saving for retirement may allocate 80% to stocks and 20% to bonds given the long timeframe. On the other hand, a 60-year old nearing retirement may prefer a 50-50 allocation. Asset allocation allows investors to customize their desired balance of risk versus reward.
The investment risk versus reward equation demonstrates the relationship between the amount of potential profit and potential loss. Balancing risk and reward through diversification and asset allocation allows investors to maximize returns for a given risk profile. Understanding this tradeoff is key to successful long-term investing.