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Course: Financial Literacy > Unit 7
Lesson 2: Risk and return of investment optionsInvesting: Risk and return
Risk and return are two important concepts to understand when it comes to investing. Different types of investments have different levels of risk and return, and investors should choose options that match their goals and risk tolerance.
What is risk and return in investing?
When you decide to invest your money, there are two important things to consider: risk and return.
Risk is the uncertainty or variability of the outcome of an investment. In simpler words, it means that there's a chance your investment may not make as much money as you hoped, or you could even lose some or all of your investment.
Return, on the other hand, is the gain or loss from an investment over a period of time. It tells you how much money you made, or lost, on your investment. If you have a positive return, that means your investment has made money. If your return is negative, then you have lost money.
How are risk and return related?
Risk and return are related because generally, the more risk you take with an investment, the higher the potential return. But, taking more risk also means more potential for loss.
Factors that influence risk and return include the type, quality, and duration of the investment, the market conditions, and the investor's behavior. For example, if you invest in a company with a strong track record, your risk might be lower, but so might your return. On the other hand, if you invest in a new company with an unproven track record, you could make a lot of money if the company succeeds, but you also risk losing your entire investment if the company fails.
Risk: How can I tell how risky an investment is?
We group investments into three categories: low risk, high risk, and moderate risk and return. It is hard to know how well an investment will do, but there are some general groups we can put them into:
- Low-risk, low-return investments: Treasury bills are an example of this type of investment. They are issued by the government and are considered very low-risk, but they also offer lower returns compared to other investments.
- High-risk, high-return investments: Penny stocks are an example of this type of investment. These are stocks of small companies that trade at very low prices. They can offer huge returns if the company does well, but they also carry a higher risk of loss.
- Moderate-risk, moderate-return investments: Index funds are an example of this type of investment. These are funds that aim to match the performance of a specific market index. They offer diversification and generally have a lower risk than individual stocks, but they can still offer decent returns.
As you can see, we do not have a low-risk, high return (everyone would invest into that) or high-risk, low-return (why would anyone invest into that?). So, remember, risk and return always go hand-in-hand - when one is low, so is the other one, and vice-versa.
| Risk & return | Types of investment |
|---|---|
| Low-risk & low-return | money markets, treasury bills, bonds |
| Moderate-risk & moderate-return | mutual funds, index funds |
| High-risk & high-return | stocks, cryptocurrency, |
Return: Return on investment (ROI)
Imagine you have
Knowing how to calculate ROI can help you decide where to put your money, whether it's a company stock, a business, or even a college savings account. Smart choices today can lead to big rewards tomorrow.
To calculate the return on investment (ROI) for an investment, you can use this simple formula:
For example, if you invested
This means that you made a
But, also, if you invested
A lot of the time, you can find the ROI for different investments online. So, you don't have to do any math. This is helpful when you're trying to decide what to do with your money, like buying stocks or investing in general.
But sometimes, you can't find the ROI on the internet, or you're starting your own business. In that case, it's important to know how to calculate ROI on your own.
Rule of 72
Now that we know what ROI is, we can take investment planning one step further - into the future!
For this, you need the Rule of 72. The Rule of 72 is a simple math formula that helps us estimate how long it will take for our money to double when we invest it. All we have to do is divide the number
For example, if we invest our money and earn an interest rate of
Why is the Rule of 72 useful?
The Rule of 72 is helpful because it shows us the power of investing and how our money can grow over time. When we invest, we want our money to grow and make more money for us. By using this simple rule, we can quickly see how long it will take for our money to double at different interest rates.
How can we use the Rule of 72 with ROI?
Remember, ROI helps us figure out how much money an investment makes. We can use the Rule of 72 together with ROI to see how our money should behave in the future.
For example, imagine you invest
Conclusion
In conclusion, investing is one way to grow your money and reach your goals faster. Remember, higher risks often lead to higher returns, but it's important to be smart about it. Keep the Rule of 72 in mind to quickly estimate how long it'll take to double your investment. Next, start learning about investment options and make your money work for you, as you step into the world of financial growth and success.
Want to join the conversation?
Why is it 72 specifically and not any other number?(7 votes)
I asked Khanmigo and this was the response that I got:
"""
The Rule of 72 is an approximation that comes from the formula for exponential growth.
The actual formula for the time it takes to double an investment is:
Time to double =ln(2) / ln(1 + interest rate)ln(2)is approximately equal to0.693.
For small interest rates,ln(1 + interest rate)is approximately equal to the interest rate itself.
"""
This makes time to double approximately0.693 / interest rate.
Now remember that interest rates are a decimal (8% -> 0.08). In this example, the time to double would be0.693 / 0.08.
That's not easy to calculate in your head though! To simplify it, let's multiple the top and bottom by 100.69.3 / 8
This is a little better but 69.3 is not easy to divide. We'll round up to 72 because that is a much easier number to divide by.
So finally we are left with72 / 8 = 9.
Although not exact, this approximation is usually good enough to determine how long it will take for your investment to double.(12 votes)
Dear Fellow Students,
After I watched the video, I scoured the internet about Penny Stocks (I'm a curious 15-year-old... can you blame me?). I saw a chart with different company statistics on it, read into it, and it looked pretty cool. However, while in the midst of my imaginary hunt for something I couldn't quite name, I found something intriguing...
I saw that a man named Warren Buffet and his accomplice had gotten in trouble with the Federal government for manipulating the price of penny stocks. My question is How Exactly??
I think that paying more than the average $5 per stock would benefit the business. So can someone please explain this to me?
Lots of thanks
- Izzy <3(6 votes)
SHould I invest in roblox stock(5 votes)
Have you checked with your broker? She may be able to check for you on that particular stock and tell you if it's a good idea.(1 vote)
If penny stocks are high risk, does that mean the relative loss is risky? Since they trade at low prices, you wouldn't lose too much if they fail, but will gain a lot if they succeed, why is this considered "high risk"? Is it the idea that what you put in will likely disappear, even though they aren't particularly expensive?(3 votes)
At what age should I begin investing in these financial markets (stocks, bonds, mutual funds, etc.)?
Is there a strategy for a "beginner" investor?
Are there investments that are better (and less riskier) than in financial markets?(1 vote)- I'm assuming that you are not yet 18 years old, and legally able to invest in your own name. So, either get a trust account where your parents control things for you, or just wait.
Whatever your age might be, don't begin investing until you have saved the necessary emergency fund.
Even if you are legally entitled to invest, as a "beginner" you should rely on an advisor, who will charge you some money for the advice, but will help you avoid losing the money based on your own inexperience.(3 votes)
Can you make a lot of money in just one year instead of getting $1,000 every 9 years(1 vote)- Investments can make a lot more than that when done wisely. BUT, investments can also lose it all. So don't be greedy, and understand the risks you are taking.(3 votes)
What is index funds and penny stocks?(1 vote)- Should I invest now?(1 vote)
- You haven't said when "now" is. Are you 13 or 31? The answer will be different depending on your "now".(1 vote)
- Why is it 72 specifically and not any other number?(1 vote)
- Actuarial science may have the answer to that. I'm not an actuary, though.(1 vote)
In the "Return on Investment" section, in the second paragraph, it says, "whether it's a a company stock". This is a mistake, right? Will it get fixed?(1 vote)
Thanks, Evelyn. Definitely a typo. We are fixing it!(1 vote)