Risk versus reward

Risk and return are both fundamental aspects of investing. We investigate how the relationship between the two is essential for success.

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Risk and reward are two of the most fundamental concepts in investing – striking the right balance between the two is essential for any investor's success. In this article, we look at how you can measure and manage your portfolio risk exposures to maximise your returns.

What is risk and reward?

In investing terms, 'risk' refers to the potential for you to suffer a financial loss. Put simply, the riskier an investment is, the more likely you could lose your money.

Typically, we consider junior companies, growth stocks, and other speculative investments (like cryptocurrencies and some forms of financial derivatives) higher risk because they can be complex for investors to understand. Or there might be less information about them, making it harder for investors to make fully-informed investment decisions.

'Reward' refers to the financial return (usually in the form of capital returns or dividends) an investor receives from investing. Suppose you buy $1000 worth of a company's stock. If a year later, the value of your investment has increased to $1,100, you have earned a return or 'reward' of $100 (or 10%).

The two concepts of risk and reward are intrinsically related. Investors usually expect to receive a greater reward as compensation for taking on more risk – otherwise, why would they bother doing it? If you could earn the same reward on a low-risk investment as a high-risk one, you'd always choose the low-risk option.

One of the main goals of any profitable investment strategy is to achieve the maximum reward for a given level of risk. You decide on the amount of risk you feel comfortable taking on and then seek out the investments within those risk thresholds that offer the best returns. 

One of the most common financial metrics investors use to help them achieve this outcome is the risk/reward ratio. More about that later.

Exploring your risk tolerance

When it comes to investing, the mantra of 'the bigger the risk, the greater the return' is not always the best rule to live by. Approaching portfolio construction with just this in mind fails to adequately consider your personal situation and investing objectives. These factors are also vital to your ongoing investment success.

Before you start choosing shares for your portfolio, you must fully understand your personal risk tolerance and return objectives. The degree of risk exposure that suits one investor can be very different from the next. 

Some investors (especially those with longer investment time horizons and more money to lose) may be happy to risk more money to chase higher potential rewards. More cautious or conservative investors might instead choose lower-risk investments, even if the potential reward is lower.

There are also many different types of risks you should be aware of. A gold exploration company will carry other risks to a growing tech stock, which will hold very different risks to an international retail stock

This means that they will pay out their rewards or returns in different economic scenarios. Diversifying your portfolio by exposing yourself to different risk factors is one way to manage your overall portfolio risk.

By assessing your risk profile, you can evaluate just how much money you feel comfortable risking, regardless of any likely reward. An excellent way to test out your risk tolerance is to try this quiz.

Carrying risk on investment

Investment risk is inevitable, so it's essential to approach any investment with your eyes open – and to try and maximise your potential return. This means there are many important factors to consider when deciding whether it's worth taking on the risk of a particular investment. 

For instance, when inflation is high, you should consider whether the return an investment promises will keep up with inflation. In this case, the 'real' value of any reward is essentially eroded as the purchasing power of money decreases (this possibility is higher for fixed income and cash equivalent investments, such as treasury or municipal bonds).

Similarly, consider the fees or other costs associated with your investments. This is especially true if you invest in exchange-traded funds (ETFs) or managed funds. If the management fees or transaction costs are especially high, they can also eat into your potential returns.

You should also carefully consider the purpose of your investment portfolio. Consider why you are investing and whether the anticipated rewards will be high enough to meet that goal. For instance, if you are planning for retirement, ensure you don't come up short with insufficient returns for your future needs (or risk so much that you threaten your quality of life).

Finally, reflect on the consequences of losing your principal on an investment: What would it mean to you personally if you lost everything you ventured? Would it result in you being unable to meet your day-to-day expenses or force you to sell other assets you own before you were ready to? If this is the case, perhaps you should invest in safer, less risky assets.

Reflecting on the answers to these questions will clearly indicate the level of risk exposure you are comfortable with and will help shape your overall risk strategy.

How to manage portfolio risk

Once you have assessed your personal risk appetite and begun to choose investments that suit that profile, there are additional steps you can take to manage your risk. This can help you to maximise your returns without exceeding your risk tolerance.

You can use many tools, tips and investment strategies to achieve these goals, but we have listed a few below.

Limit and stop-loss orders

You can lodge an order to buy or sell a particular stock with your broker in a few ways. The most straightforward is simply to put through a market order. This means you buy or sell the shares instantly (assuming the stock market is open) at the current market price.

However, you can execute other types of orders that will give you more control over the prices at which you buy or sell shares. One of these is a limit order. This is an order to buy or sell a stock at a specific price (or better).

So, if you have your eye on a particular stock currently trading at $12, but you think it offers better value at $10, you can place a limit order to buy the stock at $10. The trade will only execute if the share price falls to the level of your limit order (usually within a specified timeframe, like the next 30 days). Making your trades this way helps ensure you only pay what you are comfortable with for a particular stock.

A stop-loss order is similar to a limit order but helps reduce your downside risk. For example, you may own shares in a company that has a contentious earnings result coming up. If the result is positive, you are happy to hold onto your shares. But if the news is negative, you want to limit the financial loss on your position.

In this case, you can put in a stop-loss order below the current market price – at whatever price you'd be happy to cut your losses and run. This gives you certainty about the maximum loss you will make on the investment, thereby helping to manage your risk.

Other risk management techniques

Some investors use options and other financial derivatives to manage their risk exposures. For instance, investors could buy put options for stocks they already own to hedge their bets if they believe the share price might fall. Put options payoff when the stock price falls, which offsets the losses you would suffer from owning the shares.

However, options and other financial derivatives can be complicated and often come with their own set of unique risks. This means that it isn't realistic – or even advisable – for every investor to use these hedging techniques in their portfolios. Some brokers won't even allow everyday investors to trade these types of securities because they are highly risky.

Although this means that derivatives are out of the reach of many investors, there are other (more uncomplicated) strategies all investors can easily implement to earn better risk-adjusted returns.

Diversify across companies, sectors, geographies

Diversifying your investments is one of the simplest and easiest ways to reduce your overall portfolio risk and still earn good, stable returns.

As mentioned earlier in this article, different investments come with various risks. For example, companies operating in other geographies may carry political or regulatory risks that companies operating in Australia do not. 

Mining companies may be overly exposed to changes in the prices of certain commodities, which also carries unique risks. Other companies may operate in industries with high technological obsolescence risk, which also has specific risks (and opportunities!).

By diversifying across several different companies, sectors and geographies, you can offset your exposures to certain risks. This is because different stocks will respond differently to news events or other economic changes. For example, lower interest rates might hurt banking and insurance stocks, but they are usually great for growth stocks, like those in the tech sector, that need to borrow more money to expand.

If you owned a combination of these different shares, you could reduce the overall volatility in your share portfolio because while one stock price falls, another rises. Again, this helps you manage risk by giving you more certainty about the value of your share portfolio, regardless of what is happening in the broader economy.

Invest in index funds and ETFs

Diversifying can be expensive for everyday investors. You must pay brokerage and other transaction fees each time you execute a trade. These can quickly add up over time, significantly if you are diversifying across many investments.

Investing in index funds and exchange-traded funds (ETF) can be a cost-effective way for investors to gain diversification benefits without losing too much of their returns to transaction fees. This is because these funds trade on the ASX (and other stock exchanges) just like regular shares but are backed by a portfolio of investments.

Index funds are particularly popular. They allow you to invest in every stock on a particular index – like the ASX 200 – in a single trade. The fund regularly rebalances to ensure its holdings match its benchmark index, which should also ensure its returns track closely with those of the overall index.

Adopt a dollar-cost averaging investment strategy

Another way to reduce your portfolio volatility and, by extension, your risk is to adopt a dollar-cost averaging strategy. This involves breaking up your money into smaller chunks and investing these regularly over time, rather than all in one go at the outset. The trick to dollar-cost averaging is making your investments consistently, regardless of market conditions, and keeping up these regular payments over the long term.

Just as diversifying your investments across multiple different companies reduces your exposures to certain risks, so too does diversifying your investments over time. This means your portfolio isn't overly impacted by time-sensitive events, and (thanks to the magic of compounding) it's a great way to accumulate wealth over the longer-term.

What is the risk/reward ratio?

The risk/reward ratio is an important risk management tool used in investing. The ratio measures the financial payoff (or reward) you can expect to receive relative to every dollar you risk on a potential investment. This is a common way for investors to identify the investments that offer the best 'risk-adjusted' returns.

Despite its usefulness in measuring the relationship between risk and reward, the risk/reward ratio is only one tool investors can use when choosing between investments. 

Like any other financial metric, the risk/reward ratio is best used with other forms of analysis when making investment decisions.

How to interpret the ratio?

The risk/reward ratio is surprisingly easy to apply and interpret, which is one of the main reasons it is so popular among investors.

As the name suggests, this ratio considers risk versus reward, comparing projected benefits with the assumed investment risk. For example, a risk/reward ratio of 1:2 indicates that investors would expect to earn $2 for every dollar invested. Meanwhile, a ratio of 1:6 shows a prospective return that's six times the dollar value of the money initially risked.

While many factors can influence an investment's risk and return profile, the higher the risk/reward ratio, the riskier the investment. 

For example, a junior tech stock will probably have a high risk/reward ratio because it is a small company with an unproven track record. Because of this, it will try to attract investors by promising significant future growth – so although the investment risk might be high right now, getting in early means the potential payoff for investors could be substantial.

The purpose of the risk/reward ratio is to assist investors in balancing their risk exposures with their returns. The ratio can be a great way to screen potential investments to ensure they fit within your personal risk tolerance and return objectives, especially when first building your share portfolio.

How it works in practice

So far, we've covered the basics of the risk/reward ratio and how to interpret it. But how do you actually use it in practice?

The ideal ratio is up to the individual and will vary depending on your trading strategy, financial objectives, and risk tolerance. Deciding how to balance risk and reward is a matter for individuals to trial over time, eventually determining what ratio works best for them. However, many analysts recommend an optimal risk/reward ratio of around 1:3.

A ratio like this indicates that the stock offers excellent long-term growth potential, returning $3 for every $1 invested. However, it also likely falls within a typical investor's risk appetite, given the returns it is promising are not as astronomical as many junior tech growth stocks or other speculative investments.

Navigating risk vs reward in volatile times

In volatile markets, prices change more frequently and often move up and down by substantial amounts. This increases the likelihood that investors will lose money on their trades and makes investing riskier.

Risk/reward ratios are still valuable tools in these conditions, but they must be approached cautiously. As share prices change more frequently, so can the potential returns. For example, an analyst may have a specific price target for a stock based on an analysis of the company's underlying fundamentals. But what sort of return on investment that price target presents can vary substantially depending on the stock's current price.

This means that in volatile markets, the calculated risk/reward ratios for various stocks can change frequently. This presents challenges for short-term and day traders who trade often and use the risk/reward ratio to influence their investment decisions.

However, here at the Fool, we advocate for long-term investments in high-quality, growth-oriented shares. A long-term view is the best way to look beyond short-term share price volatility. Look for stocks that tap into developing economic trends, as these shares will offer the best long-term growth potential. It is also more likely that short-term price fluctuations won't unduly influence their risk/reward ratios.

What level of risk is right for you?

Each investor's risk profile will be different, as it will depend on their own personal financial situation, age, temperament, and investing goals (among countless other things). The bottom line is that you should never risk so much of your money that the prospect of losing it all makes you wake up in a cold sweat each night.

Also, take into account how soon you will need your money back. Investors with a longer time horizon can afford to take on some riskier investments, as they have the time available to wait around to see if they pay off. If you need your money back in the shorter term, you should avoid overly risky assets in case they decline in value and you are forced to sell them at a loss.  

Understanding risk is the key to reducing and managing it. This includes knowing how to use risk minimisation tools such as the risk/reward ratio, limit and stop-loss orders, and other investment strategies. But it also requires you to be mindful of your own personal risk appetite. Having all this information to hand will ensure you always make the best-informed investment decisions. 

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