Most experts agree that use of risk/reward ratios is limited, as they do not take into consideration the probability of attaining a certain target or goal, or the probability of a certain downside risk. But through careful research, you may see the potential high and low. The model also does not take into consideration time or the occurrence of a macroeconomic event that may, in the short term, radically change the price of your investment, thus affecting our reward. So use risk/reward ratios as only one tool when making investment selections.
What is the progression of risk, from low to high, among different classes of investments?
Normally, each type or class of investment carries its own reward and risk associated with the investment that may be plotted on a graph. Moving from low potential return/low risk to high potential return/high risk, there are short-term government debts (from financially secure sovereign nations); mid- to long-term government debts, shortterm loans to the highest rated blue chip corporations; real property that is purchased and then rented or leased; high-yield debt to less stable governments and lower-rated corporations (junk bonds); equities (including small, medium and large capitalized corporate equities); and options and futures contracts (wherein you leverage or borrow funds in order to purchase an investment).
What is the theoretical risk-free investment, and why is it so important?
The theoretical risk-free investment is the return that an investment may bring from an investment that carries no risk. The problem with this definition is that there are no truly “risk–free” investments. Even keeping cash under your bed is risky, as it could be lost or stolen. Also, inflation of prices over time—coupled with government monetary and fiscal policies that may change with different political regimes—may reduce the value of that cash under your bed. So risk-free investments exist only in theory, but are still highly important because they allow you to compare the risks of other investment choices.
Younger people can tolerate more risk in their investments because they are in it for the long haul.
Does my tolerance to risk depend on my age or stage in life?
It is commonly thought that younger people should be more tolerant of risk, for a few good reasons. When you are younger, you may have the opportunity to earn and keep earning money to replenish any losses you may incur. You also have a much longer time horizon in which to offset your losses with gains, should you make an improper investment decision. People nearing retirement may need access to their portfolios in order to provide daily income—and therefore would likely have less tolerance for risk—than someone in his twenties who has many decades of earnings and returns ahead of him.
What is “systematic risk”?
Systematic risk is the risk associated with broad events that affect the entire market or market sector that cannot be mitigated through diversification.
What is “unsystematic risk”?
Unsystematic risk is the risk associated with a particular industry or market sector that can be mitigated through having a diversified portfolio of stocks.
What is a “risk/return trade-off?”
A risk/return trade-off is the principle that the higher the level of uncertainty as to a potential return, the higher the reward. An investment with a relatively predictable low level of uncertainty will have a lower return. This is why individual investors must clearly understand their personal tolerance for risk in order to make the right choices when investing in individual stocks.
How many individual stocks must I own to have enough diversification against unsystematic risk?
Although many experts disagree with assigning an exact number, a diversified portfolio of individual stocks should fall within a range of between 12 and 25 stocks. The answer may be quite complex, as it based upon your tolerance for risk. Investors who are quite riskaverse will seek more diversification, and hold more individual positions. In contrast, an investor with a high tolerance for risk may hold fewer individual positions.
How do professional investors feel about risk?
Many professional investors believe the mitigation of risk is probably as important as analyzing and making specific investments. Over time, investors are rewarded with higher returns in exchange for putting their money at higher risk. But many professional managers believe you can mitigate risk by buying and holding various assets over time, and selecting assets with minimal correlation, so that if any one asset decreases in value, others may increase in value or be unperturbed by the cause of the decline. By diversifying your portfolio with uncorrelated assets, you may be able to experience increases in the values of your portfolio without having to deal with sharp declines.
Why is risk a standard deviation?
As we compare how a potential investment performs against a benchmark, and how far this performance deviates from a norm, the risk can be expressed mathematically, indicating how precarious the investment may be. In other words, the further from the norm, the riskier the investment.
What types of risk exist?
Risks to our investments may be categorized as market risk, default risk, inflation risk, and mortality risk.
What is “market risk”?
Market risk is an investor’s risk in incurring losses due to price movements. There are many types of market risks, as there are many different markets in which we can invest. Some of the most common risks include: Equity Risk (the risk that an individual stock, index, or mutual fund price or the volatility of that investment may change); Interest Rate Risk (the risk that interest rates, the price of money, or the volatility of these categories may change); Currency Risk (the risk that the price of a foreign currency relative to another currency, or the volatility of this price, may change); Commodity Risk (the risk that the price of a particular commodity a company uses, or the volatility of the price of this commodity, may change).
What is “default risk”?
Default risk, or credit risk, is the risk associated with investments in which the company cannot pay its debt obligation. Lenders and investors are always exposed to default risks. Our financial system is built in part on mitigating the effects of these risks by having lenders pay a higher return on a relatively riskier investment, and lower returns on a relatively safer investment. Risks to lenders include loss of principal and interest, disruption in expected cash flows for these payments, and costs borne by the lender in his attempt to collect the amount owed.
Why is “inflation risk” bad for my portfolio?
Inflation, the increase in prices over time, gradually erodes the value of your money. Since 1926, the gradual increase in prices has increased, on average, by approximately 3% per year. In some outlying years, the increase has been very high—approximately 13.5% in 1980, and averaging approximately 6% during the 1980s. This means that if you are planning for retirement soon, you may need much more saved and invested in order to have adequate income later on, as the value of your money may be less because of this inflationary price tendency.
What is “mortality risk”?
You will certainly die. It could happen during the next hour, day, or year, and insurance companies price their products accordingly, using actuarial calculations to factor the probability of the timing of your mortality. Regarding your pension or other post-retirement benefits, your mortality risk is generally accepted to be the risk of dying earlier than expected while you earn such benefits.
What is the opposite of mortality risk?
The opposite of mortality risk—and another important consideration when it comes to considering our retirement planning—is our longevity risk, the risk that we live longer, and therefore have more need for income, than expected.