How to Balance Risks & Rewards in Investing
The key to building the right portfolio is to balance risk and rewards. That might sound straightforward enough, but it can be deceptively challenging for most investors. Determining how to balance risks and rewards in investing looks different for everyone, and one’s own definition of risk is likely to differ from someone else’s. Risk takes on different forms and levels of influence in your portfolio depending on a host of factors.
Knowing which elements of risk have the greatest impact on your investing strategy is the most important thing smart investors can do. Undertaking the balancing act of managing risk and reward in investing means knowing the basics, understanding the role of risk in a healthy portfolio, and better incorporating risk into your portfolio in a way that makes the prospective reward worth the cost.
What Does Risk and Reward Mean for Investing?
We know that every investment comes with risk—be it an investment in real property, stocks, bonds, or participation in a hedge fund. There is always a chance that, when you put money toward an investment, that you won’t make a return on your investment. Worse yet, there’s always a chance that you’ll be out as a result, too.
This is a broad definition of what risk means in terms of investing. You may make no money, less money, or even lose money on an investment—irrespective of what the opportunity was when you first decided to take part in the investment.
For example, let’s say you were to buy high-yield bonds (or junk) bonds. High-yield bonds offer higher interest rates than investment-grade bonds as a premium of sorts, to help incentivize people to invest in their bond. The risk here is that the company behind the bond will not be able to pay back its investors. But, on the other hand, the higher interest that high-yield bonds offer could end up giving the bondholder a higher return on their investment. The risk of not getting one’s money back—let alone making a profit on it—is larger; but the possibility of a high payout is also greater.
Why Risk Can be a Good Thing
Risk isn’t something we embrace with open arms (well, at least those of us who don’t count BASE jumping as a hobby). People are by and large averse to risk when making investments, even if risk is an inherent component of how investments make money. In fact, behavioral finance researchers call this phenomenon “prospect theory,” which is the notion that losses loom larger than gains when it comes to investing. People have a predisposition to build a financial strategy that emphasizes retaining money, rather than one that puts gains at the fore.
Despite the role of prospect theory in many investors’ methodology, almost every investor assumes some level of risk. Any time you take money out of a bank account—be it a checking or savings account—to invest in a stock, bond, mutual fund, or index fund, you’re exposing yourself to the risk that your investment will lose money.
Not all of these investments are created equally as far as risk goes. Some, like mutual funds, are designed in a way that minimizes risk in favor of steady returns. Others balance risk with reward, such as stock ownership. On the other end of the spectrum are some kinds of alternative investments, such as participation in hedge funds and private equity firms. These investment options require a high minimum investment, run a larger risk of losing value, and also offer a much higher return in the event that their investments work out.
Determining Your Appetite for Risk
Incorporating risk into your financial strategy is a balancing act. If you try to shy away from risk entirely, be it through high-yield savings accounts or CDs, you’re more likely to get steady returns. Odds are, your returns are going to be small and may only keep pace with inflation. This isn’t necessarily a great financial strategy if growing your assets is a primary goal.
On the other hand, building a portfolio that overemphasizes riskier, high-yield investments can threaten to wipe out your funds. There’s a chance you may strike it big with at least a few of these investments, but your odds of losing value are far greater.
The smart financial move is to build a diverse portfolio that runs the gamut of conservative and riskier investments: low-risk plays can offset losses from high-risk investments, or at least preserve some of your portfolio’s value if the gains from a riskier, higher-yield investment have yet to materialize. How much of either kind of investment you choose depends on your overall appetite, or tolerance, for risk.
How to Maximize Reward while Minimizing Risk
Not all high-reward investments are equally risky, mind you. Take alternative investments, for example: some are high-risk (options trading, venture capital), while others have less risk with the prospect of still garnering a high return on investment.
Take farmland investing for example: this investment class offers a unique set of opportunities that offer returns that beat Wall Street. But, unlike other investment vehicles that offer outsized returns, the level of risk that comes with farmland investing is much lower. Farmland real estate has been historically steady, and tends to hold value more than other real estate classes. Plus, with farmland investing, you can enjoy diversified revenue streams that combine real estate value and profits from harvest season—all while having your passive investment work for you.
No matter how you evaluate your investments, it’s crucial to be willing to understand your appetite for risk versus the kind of returns you want to get. A risk-averse portfolio may keep up with inflation and enjoy gains that track with the Dow Jones Industrial Average, but they give up the chance of a big return by playing it safe. Knowing where to incorporate risk, even in the most conservative portfolio, can help you maximize returns without too much exposure.
Striking the Balance Between Risks & Rewards in Investing
Balancing risk in your portfolio means understanding how much exposure you’re willing to have to the prospect of an investment not panning out. The old adage that putting one’s eggs in more than one basket rings true here: having a moonshot investment play in your portfolio can yield massive returns, but it can also end up leaving you in a precarious position financially if things don’t come to pass.
But if you have a well-built, robust portfolio, you can avail yourself to the upside of a high-risk investment without leaving your financial strategy in tatters. Knowing your own appetite for risk means understanding how you want to build your ideal portfolio, and what you’re willing to give up if something goes bust.
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Disclaimer: FarmTogether is not a registered broker-dealer, investment adviser or investment manager. FarmTogether does not provide tax, legal or investment advice. This material has been prepared for informational and educational purposes only. You should consult your own tax, legal and investment advisors before engaging in any transaction.