Chapter 3. What is risk assessment? What is risk versus return?

The risk-reward tradeoff could easily be called the "ability-to-sleep-at-night-test." While some people can handle the equivalent of financial skydiving without batting an eye, others are terrified to climb the financial ladder without a secure harness. Deciding what amount of risk you can take while remaining comfortable with your investments is very important.

 

How to

In the investing world, risk is defined as the chance that an investment's actual reward will be different than expected. Technically, this is measured in statistics by the "standard deviation concept". Risk means you have the possibility of losing some, or even all, of your original investments. There is a strong correlation between risk and reward:

• Low levels of uncertainty (low risk) are associated with low potential reward
• High levels of uncertainty (high risk) are associated with high potential reward

 

 

The risk/reward tradeoff is the balance between the desire for the lowest possible risk and the highest possible reward. Assessing what risk level is most appropriate for you is not an easy charge. Risk tolerance is different from one person to another.

If you find yourself as a ...

• ...low to moderate risk taker
  • You are comfortable in using:
    • Saving and checking accounts
    • Money market accounts
    • Certificate of deposits
    • Government secure bonds
    • Mutual funds
• ...moderate to high risk taker
  • You are comfortable in going after:
    • High-risk stocks
    • Commodities
    • Real estate
    • Foreign investments

To strike a balance in the risk/reward trade-off, investors are advised to take a common path towards diversification, which is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. The goal is to reduce the risk of volatility by investing in a variety of assets. This mixture of assets will look different based on your risk level.

 

Practice

Now that you know that risk assessment is more about your risk tolerance than about the investment itself, think of paying it forward and discuss risk versus return and the concept of diversification and allocation of assets with a friend or a family member.

 

Congratulations! You can move on to Chapter 4. Savings and investment vehicles, what is the difference?

To review the full module on Saving & investing, click here.