Understanding Risk

by Adam on May 12, 2010

This is part 1 of ‘Understanding Risk’: There’s so much to discuss I’ve decided to split this post up into several parts.

When you first start reading about  ‘investing’ you’re going to come across the word ‘Risk’ a lot. It’s a concept that is easy to understand on the surface but to fully understand the concept and the implications for growing your pennies over the long term takes a little more time.

Are you intimidated by the stock market?

Risk is one of the main reasons why people think investing is scary (or believe it is downright dangerous!).

The dictionary definition doesn’t help matters either:

noun

1 a situation involving exposure to danger.

2 the possibility that something unpleasant will happen.

However, when it comes to investment risk, it helps to think of risk as merely a range of possible values at any point in time:

  • A high risk £10 investment could grow to £20 or go down to £5.
  • A lower risk £10 investment could grow to £15  or go down to £7.
  • A ‘No risk’ investment could grow to £12, but not fall to less than the original £10

A more extreme case could be a £1 lottery ticket: an extremely high risk item with an extreme range of possible outcomes: it could be worth £1 million or it could be worthless.

Why some investments are more ‘risky’ than others

Investment risk is more about unknowns than actual ‘danger’ (unless you are investing money that is vital to you –something you should never do). Think about the lottery ticket: people are willing to pay £1 for a likely worthless ticket because they don’t know its true value.

Incidentally, loans are a form of risk too. For example, when taking out online payday loans make sure you have the means to steadily pay it back. Loans are meant to help you stretch your assets- not replace them.

Risk-Free

In contrast: for a savings account, everything is known: the bank makes a promise to pay you a certain interest rate and promises you that your account balance will not go down. The range of values that your account could ever be is small because everything is known –you know you will not lose money, and the bank knows they only have to pay you a certain interest rate.

High Risk

 

 

Compare this to a more ‘risky’ investment, perhaps a share in a small oil company. Investing in individual shares is ‘high risk’ because there is a huge range of possible values of that share at any one time –the company might do well, perhaps find some oil in the Atlantic ocean, and so the share price may go up dramatically. However, the company could use all its money drilling for oil and not find anything, resulting in the share price falling dramatically.

Balancing Risk

Therefore, the trick to successful investing is finding the right balance of risk for your pennies: you could decide to be very risky and become very rich very quickly, or you could lose your money just as quickly.

Or you could decide to do the opposite and avoid taking risks with your money. However this decision is dangerous in its own right as your money loses value due to inflation – it may be a less obvious danger, but if you do not take enough risk with your pennies they may be worth less over time.

Risk is therefore definitely worth getting your head around if you are to grow your pennies successfully.

There’s lots to cover  but when it comes to investing the number one rule about risk is: High Risk does not always mean High Reward, only the potential for a high reward.

Lottery ticket anyone? 😉

In Part 2 on Friday we’ll look at the benefits and pitfalls when it comes to investment risk.

Midweek Reading:

From around the web:

  • Festival of Frugality #278: The Pure Peer Pressure Edition
  • Carnival of Personal Finance #256: Market Crash Edition
  • 5 Reasons Why I’m a Student of Life, and You Should Be Too

Related Magical Penny Posts:

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