Stock trading is exciting, risky, and has the potential to be highly rewarding. The relationship between risk and reward is something that applies even outside the stock market: higher the risk, higher the reward; the more you gamble, the more you stand to win (or lose!). If you are an investor, the act of balancing risk and reward when you trade stocks is important to be successful in the field.
Case in point: Bill Gates and Jeff Bezos own large chunks of their companies, which is a key reason why their net worth is so much. At the same time, owning such a big fraction led to a loss of billions of dollars when the share price fell in December 2018. So, if you are keen to know some tips to ensure a balance between risks and rewards in investing, this article is for you.
What Sort Of An Investor Are You?
Categorized by the risk rating, investors are of three types:
- Low-risk: They invest only in safe assets and are happy with enough profits to counter inflation.
- Medium-risk: These investors tolerate some more ups and downs if they can make a profit over and above inflation.
- High-risk: They are aware of the fact that their investments can fluctuate a lot, but their target is to pursue high profits.
The risk/reward ratio marks the potential reward an investor can earn for every dollar he/she risks on an investment. This is the standard used by most investors to compare the risk and rewards of an investment.
5 Investment Tips to Balance Risk and Reward
1. Diversify Your Portfolio
A portfolio could be defined as a collection of financial assets like bonds, stocks, currencies, commodities, and cash equivalents, and their fund counterparts, including mutual and exchange-traded funds. Which assets are in your portfolio greatly depends on how risk-averse or risk-loving you are.
For example, a conservative investor might favor a portfolio with large-cap value stocks (companies with market capitalizations of $10 billion or more), broad-based market index funds, investment-grade bonds (municipal or corporate bonds that present a relatively low risk of default). On the other hand, a risk-tolerant investor might have small-cap growth stocks, an aggressive, large-cap growth stock position, and some high-yield bond exposure.
The time frame i.e., how long you plan to invest in building a portfolio, is also a factor that decides what goes in your portfolio. The general rule of thumb is that as you near the goal date, you move towards more conservative assets to protect the investments up to that point. On the other hand, if you have just started investing and plan to keep doing it for a long time, you can afford to invest in more risky stocks because you don’t have much to lose.
2. Consider Your Budget and Plan
You should consider the budget for your portfolio even before making your portfolio. Think of how the money you earn from it will be used. It could be just to fund your retirement, or it could be for an elaborate world tour.
It is a good practice to get a spreadsheet out and enter all the numbers just to see where you stand. Get the math right to check if you can afford the investment and make sure that you don’t over-invest nor under-invest. Once the budget is ready, incorporate it into a financial plan that takes into account your current savings and investments.
A plan helps you to predict some possible scenarios and risks in the future and take mitigation measures (you can also call a financial advisor to help you out). The amount of risk would depend on the portfolio, which in turn depends on the purpose of investing.
3. Look Out for Concentration Risks
The example of Gates and Bezos mentioned earlier talks about this. Having a large concentration of one stock or similar stocks can be highly rewarding if the company or industry booms, but it can lead to huge losses if the opposite happens. There may be several reasons why you want to have such a portfolio: perhaps you have some emotional attachment to a particular company.
If you are a risk-averse investor, but you still have a concentrated portfolio, one way to deal with it is to invest in exchange funds. They allow an investor to exchange an individual stock for shares in a pooled fund of many stocks, which provides diversification. However, if you are sure that the company or industry will do well, you will benefit more by dedicating a significant portion of your portfolio to the same type of stocks.
4. Invest in Real Estate Investment Trusts (REITs)
REITs are like mutual funds that invest in real estate, typically commercial real estate, including office buildings, retail shopping centers. REITs trade on major exchanges, so they are usually liquid. Moreover, these have the potential for high rewards with a sufficiently lower risk because they pay dividends (yields over 10%, higher than those you get from risk-free investments) and receive special tax treatment.
5. Understand Risk Mitigation Measures
Risk mitigation helps you to cut down losses, even if they don’t necessarily help you make profits. There are a few techniques like the wash sale rule and the stop-loss order that enable investors can plan their trades to cap losses.
Let’s look at the stop-loss order: its main purpose is to buy or sell the stock when the price reaches some threshold. For example, if a stock is worth $50 and the threshold to sell is set at $40, your maximum loss is $10. Similarly, if you set a limit of selling at $60, then you are guaranteed $10 in hand before the stock price fluctuates further.
Are You Ready To Invest?
Regardless of the type of investment, there will always be some risk involved. However, these five rules will help you plan your investment strategies better and keep you in a balanced position between risk and reward.
To test out these strategies, you can sign up for online stock trading platforms that let you trade free stocks using virtual currency. This will give you a flavor of how the stock market works without actual money involved.
Raj Kumar is a qualified business/finance writer expert in investment, debt, credit cards, Passive income, financial updates. He advises in his blog finance clap.