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Investing Basics - Risk vs. Reward
As an investor we are always trying to maximize our reward (investment return), but do we spend enough time trying to reduce our risk? The risk reward tradeoff is very simple: The higher the risk, the higher the potential return must be to compensate for the increased risk exposure. This is why very safe investments like treasury bonds, CDs, and savings accounts offer very low returns. Investments like options, commodities, and penny stocks offer very high potential returns but the risk of loss is also much greater. Therefore, the key is to maximize return while minimizing risk.
One of the best ways to reduce risk is through diversification. Diversification is allocating your investing dollars into many different investments. In effect, it reduces the overall risk of your portfolio while still maintaining a higher potential return. Diversification can be achieved in many different ways depending on your risk tolerance, age, and investment objectives.
A younger investor may want to diversify by owning stocks or mutual funds that represent many different sectors of the stock market. An aggressive investor may want to diversify by owning investments from several different countries or regions around the world. Different yet, an investor closer to retirement may want to spread their risk over different types of bonds and annuities with different maturity dates. This last example is a form of time diversification used to protect against interest rate changes.
In conclusion, I would like to emphasize the importance of evaluating investment risk as well as potential return. If an investment is offering a very high return, it is more than likely also exposing you to a high amount of investment risk. Also, when considering a new investment, determine how it will fit your overall portfolio. For example, if you are already very heavy in technology, buying another technology stock might not be the best investment. It may be fun to "ride the wave" of the hot sector, but it won't be that fun when that sector falls and the bulk of your portfolio is in that sector. Reduce your risk exposure by diversifying into other areas.
