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Current time:0:00Total duration:11:39

Video transcript

whenever people talk about investing the terms risk and a 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 all I 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 a thousand dollars and we want to figure out what we can do with this thousand dollars 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 a reward first is we'll get I don't know 1% in interest per year 1% annual annual interest so after a year we'll have roughly a thousand and ten dollars we got one percent on our thousand dollars 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 well if I'm putting it into a savings account and assuming I'm putting it into an 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's being insured by the Federal Reserve which means that if for whatever reason that that Bank were to fail above below some limit the the Fed will insure your money so even if this Bank fails and it loses all of its money and everything you'll still get your deposit back so if you're in investing or if you're putting money in an FDIC insured savings account your risk your risk is essentially zero you will get you are guaranteed to get that thousand dollars back regardless of what happens to that bank so you have very little risk there but you might say look you know this is a good risk but I feel like I can get more than 1% on my money let me let me think about the other places 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 let me maybe I could lend the money to a very reputable company so let me say lend money to reputable company reputable company and maybe this company has you know taught you know billions and billions of dollars in assets it's been around for hundreds of years it generates cash on a regular basis it's that there's really very few circumstances in which you could imagine that this company would not be able to pay off its debt and you lend money to a reputable company by essentially buying their bonds when you buy their 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 in annual interest on your thousand dollars so six percent on the first thousand on the or the first year you'd get $60.00 it's six times more than what you were getting in the savings account what's the risk here well it's not zero anymore it's not FDIC insured the Federal Reserve isn't saying that 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 is that the business defaults on the loan so the business 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 you 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 in boom times and in 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 it is a reputable company that has a lot of assets and all the rest now let's say that even that's 6% you know it's alright but you feel like you could get you could get more you could do better so let's say that you have a friend who is a let's say that he's just starting his career as a as a doctor so he has a nice stable job so he's just starting his career as a doctor so stable income stable income he's making $200,000 he's making $200,000 a year but he's just out of medical school and he figures he wants to he wants to buy a house and so he's trying to find people at you so he's just starting he wants to find people who can help him with the down payment on the house so here your reward and he says anyone who's willing to lend to me I will give them I will give them 8% annual interest on their money annual interest and 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 down payment seems well within his means to pay it but there is always some risk there is always some risk that he doesn't pay doesn't pay I mean who knows he 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 actually why he needs loans to begin with so there is some risk so that there's a risk that 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 get hit by a bus a human being can so there are you know companies for the most part cannot become alcoholics a human can who knows we don't know there 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 in the market invest in the market invest in stock market in stock market you're just going to invest in a bunch of you know 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 mark and you say 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 averaged approximately 10 percent 10 percent 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 turns returns in 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 could in any given year the market could go down in the double digits or you know the 30 40 percent even in really really bad year that we really don't you you really don't aren't sure whether you're going to get your 10 percent per year so I would say the risk here is volatility volatility and volatility just means it could go up and down it can it jumps up and down it's not going to be a constant upward trend like your savings account will be volatility volatility and you have a good chance that you could actually lose the money that you're investing it could go down in any year and any month in any five years in any ten years so once again it seems it seems like a kind of risky thing and you can very easily lose everything and let's say that even ten percent 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 who's been out of work for a little bit so then we write the brother-in-law right 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 that he can start it up in his garage and the reward the reward and there's multiple ways we could set up the reward we could make it so that he borrows the money for you we can 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 in the business and let's say that your brother or law is right and this becomes a million dollar business and it becomes a million dollar business million dollar business so this is a very very very high reward if what your brother-in-law is telling you 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 lose everything and not only could you lose the the monetary money that you put in it could also ruin your relationship with your brother-in-law and maybe your spouse so risk relationships relationships maybe I should put your risk family family happiness once your brother-in-law loses all of your money won't be so easy at Thanksgiving anymore to have a have a civil conversation so in general the over line 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 reward you should expect to get or if the more reward that you're expecting to get there's probably some risk there and if there's if there's something that looks like it's really safe with really high reward one of those two things are probably not true so if we were to plot all of these and I haven't really quantified I haven't I haven't kind of given you a way of 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 a savings account over here it's zero risk 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 higher 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 the risk is a little bit higher than lending to that company or savings account once again a little bit higher reward a little bit higher reward you now have an 8% reward investing in the stock market let me pick a color I haven't used yet investing in the stock market once again higher risk but also high 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 reward so maybe it might be like that but the general idea is the more risk the more reward