Risk and Reward Introduction Basic introduction to risk and reward
Risk and Reward Introduction
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- Whenever people talk about investing
- the terms risk and reward tend to come up a lot
- and they usually tend to come up
- together, somehow implying that the more risk you take the more reward
- that you might be able to get, and that's
- actually what it is implying.
- But what I want to do in this video
- is give a little bit of an introduction to that
- or a little bit context, a little bit more structure
- on how do you think about risk and reward.
- So let's say that we have $1,000
- and we want to figure out what we can do with this $1,000
- well, one option is we could just put it into a savings account
- so here is one option,
- so we could put it into a savings account
- and in this situation our reward, I'll start with the reward first,
- is we'll get, I don't know, 1% in interest per year
- 1% annual interest, so after a year we'll have roughly $1,010
- we got 1% on our $1,000. So we get a little bit of reward
- what's our risk?
- So the risk here, I'll write risk in a different color
- what is the risk here?
- We'll if I'm putting it into a saving account
- and assuming I'm putting it into and FDIC insured savings account
- let me put that over here,
- if you do open a savings account it should be FDIC insured,
- that means that it means it's being insured by the federal reserve
- which means that if for whatever reason that bank were to fail
- above, below some limit, the Fed will insure your money
- so even if the bank fails, and it loses all of it's money and everything
- you'll still get your deposit back.
- So if you're investing, and you're putting money in an FDIC insured savings account
- your risk is essentially 0. You are guaranteed to get that $1,000 back
- regardless of what happens to that bank,
- so you have very little risk there.
- But you might say, look, this is a good risk
- but I feel I can get more than 1% on my money
- let me think about the other place that I could invest it.
- Well you could, and obviously I'm not going to be exhaustive on all of the different
- investment options, I just want to give you a sense of risk and reward,
- you could say well maybe I could lend the money
- to a very reputable company, so let me say
- Lend Money to Reputable Company.
- And maybe this company has, you know,
- a ton, billions and billions of dollars in assets,
- it's been around for hundreds of years,
- it generates cash on a regular basis,
- there's really very few circumstances in which you could imagine
- that this company would not be able to pay off it's debt.
- and you lend money to a reputable company by essentially buying their bonds.
- When you buy a company's bonds, you are lending money to that company,
- so that's just the way you should think about it.
- So the reward here, if you lend your money to this company
- they will pay you 6% in annual interest on your $1,000
- So, 6% on the first $1,000, on the first year,
- you'd get $60, this is 6 times more than what you were getting
- in the savings account. What's the risk here?
- Well, it's not 0 anymore, it's not FDIC insured,
- the Federal Reserve is not saying they'll either
- give the money if the bank goes out of business,
- or they'll print the money if they don't even have it,
- here the risk is that the business defaults on the loan.
- So the Business Defaults on the Loan.
- So the company itself might go bankrupt,
- if it goes bankrupt, then all the people that the company owes money to
- will go after that company's assets.
- But maybe you are low on the pecking order,
- maybe the company doesn't have enough assets to pay everyone back
- so there is some risk, any business could go out of business
- you never know what might happen,
- but since this is a very reputable company
- and as we said it has a lot of assets, it has a very
- stable business, it does good in boom times
- and recessions, this is a low risk of business default,
- so I'll write low risk right over here
- because we're assuming it is a reputable company
- that has a lot of assets and all the rest.
- Now lets say that even that 6%, you know
- it's alright, but you feel like you could get more,
- you could do better, so let's say that you have a friend
- who is a, let's say he's just starting his career as a
- doctor, so he has a nice stable job,
- so he's just starting his career as a doctor
- so stable income
- he's making $200,000 a year,
- but he's just out of medical school
- and he figures he wants to buy a house
- and so he's trying to find people, so he's just starting
- he wants to find people who can help him with the downpayment
- on the house. So here, your reward,
- and he says anyone who is willing to lend to me
- I will give them 8% annual interest on their money
- annual interest, and it looks pretty good,
- stable income, it's only $1,000, he's not buying
- an outlandishly expensive house, he's buying a $200,000 house
- on which he wants to put $40,000 downpayment,
- seems well within his means to pay it,
- but there is always some risk, there is always some risk
- that he doesn't pay.
- Who knows? Hopefully this doesn't happen,
- maybe something happens to him himself,
- maybe he's not able to work as a doctor, maybe
- something happens to his health,
- maybe he has some type of addictive personality
- and he likes to drink away
- all of his money, or he likes to gamble it away
- and that's why he needs loans to begin with,
- so there is some risk, so there's a risk he doesn't pay
- but by all indications he looks like a pretty safe character,
- but it's definitely riskier than this company
- because you have no assets to go after if he doesn't pay
- companies can't randomly be hit buy a bus,
- a human being can,
- so there are, companies for the most part
- cannot become alcoholics, a human can.
- Who knows? We don't know. But there are definitely
- more risks associated with this individual doctor
- who does not have assets you can go after.
- But maybe this is also not enough reward,
- you're like, you know, I heard that I can do even better
- I can do better than this in the stock market
- so, you look at another option, so let's say you invest
- invest the market.
- Invest in Stock Market. And you're just going to invest
- in a bunch of, a broad portfolio, kind of investing in the market as a whole,
- the reward here would be the expected return of the market.
- So you look at historical results in the market, and you say, hey look
- it goes up and down every year, but over long periods
- of time it looks like people and
- this isn't the exact number, but it looks like people have
- average, approximately 10% per year.
- So that looks pretty good, but what's the risk?
- Well the risk is is that, this expectation is
- just based on historical, what the historical returns of the market were,
- there are huge periods of time in the market
- I'm talking 10, 20, 30 years, where the market
- is flat, where the market could even go down,
- people, in any given year, the market could go down in the double digits,
- or, you know, 30% 40%, even really bad year,
- that we really don't, you really aren't sure
- whether you're going to get your 10% per year.
- So I would say the risk here is volatility,
- and volatility just means we go up and down,
- it jumps up and down,
- it's not going to be a constant upward trend
- like your savings account will be,
- volatility, and you have a good chance you could actually
- lose the money that you're investing,
- it could go down in any year, in any month
- in any 5 years, in any 10 years, so once again
- it seems like a kind of risky thing,
- and you could very easily lose everything,
- and let's say that even 10% isn't enough for you
- You say, hey, I want to look at things that maybe I could get
- even a better return.
- So you have a, your brother in law, who's been out of work
- for a little bit.
- Let me write the brother in law over here,
- your brother in law has been out of work
- for a little bit, and he says that all he needs
- to start his new guaranteed money-making
- scheme, is $1,000 so he can buy the equipment
- so he can start it up in his garage, and the reward
- and there's multiple ways we could setup the reward,
- we could make it so that he borrows the money from you
- we could make it so that you own part of the business
- so let's say the reward is you get a 50% stake in the business
- 50% stake in business
- and let's say that your brother in law is right
- and this becomes a million dollar business
- so this is a very, very, very high reward,
- if what you're brother in law is telling is correct
- but what's the risk?
- Well the risk here is obviously that he's not correct
- and that he squanders all of your money,
- so lose everything,
- and not only could you lose the monetary money you put in
- it could also ruin your relationship
- with your brother in law, and maybe your spouse,
- so risk relationships, maybe I should put your risk family
- family happiness.
- Once your brother in law loses all your money
- it won't be so easy at thanksgiving
- anymore to have a civil conversation.
- So in general, the overlying, you know I probably did more of these scenarios
- than I needed to, but I think you see the general trend
- the more risk that you take in general
- the more of a reward you should expect to get
- or the more reward you're expecting to get
- there's probably some risk there,
- and if there's something that looks like it's really safe
- with really high reward, one of those 2 things
- are probably not true. So if we were to plot all of these
- and I haven't really quantified, I haven't kind of given you a way
- of measuring risk, in future videos we can think about that
- and academics have thought about ways of measuring risk
- so that's risk and reward, if you plot it all over here,
- so the savings account, it's zero risk, so this is the savings account over here,
- and your reward is 1%. So this is 1% right over here.
- The lending to a reputable company, it's a little
- bit higher risk, so this is this one right over here,
- it's a little bit higher risk, and your reward is 6%
- so let's say this is 6% right over here.
- So it's a little bit high risk,
- I'm just saying risk is increasing.
- If you lend to the doctor, so let me pick another color here that I haven't used
- if you lend to the doctor, once again, risk is a little bit higher
- than lending to that company, or the saving account
- once again a little bit higher reward, a little bit higher reward,
- you now have an 8% reward. Investing in the stock market
- now let me pick a color I haven't used yet
- investing in the stock market, once again,
- higher risk, but also higher reward,
- maybe 10% per year. That's 10% right over there.
- Your brother in law, super high risk
- probably off the charts over here,
- but also super high rewards, so maybe it might be
- like that.
- But the general idea is the more risk the more reward.
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