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Why are company executives paid higher than middle or lower-level management?
Besides experience, education, and problem-solving skills, executives take the responsibility for the business. Higher responsibility (risks) is compensated with higher emoluments (rewards).
Apply this concept to real-world investment decisions. If you invest your hard-earned money in high-risk investment options, you will demand a comparatively higher return.
Let’s take an example where a company floats debentures to raise money from the general public for investment in a project. Those who buy debentures are taking several risks.First, they are investing their money.Second, they vow to keep it invested. Third, they will suffer a loss if market interest rates rise.
Investors will demand a higher return if the risks are higher, more volatile, or more uncertain. The relationship between risk and reward is direct. The higher the risk, the higher the reward.
Equity Investments
The “Risk Vs Reward” concept for debenture is quite straightforward. But for equity, when it comes to investing, what is the typical relationship between risk and reward? Let’s tackle this question now.
A first-time investor might look to invest in a company with the most popular stocks in the S&P500. The inexperienced investor will resist the urge for a high return if it could lead to an investment loss.
An equity investor takes several risks:
- The company they invested in may go into liquidation
- Variation in profits from one year to another
- Variation in dividends due to variation in profits.
Stockholders earn in two ways. They get quarterly, half-yearly, or yearly dividends. An increase in the value of shares results in capital appreciation. They can sell the stocks at a higher price than what they bought for and cash out the capital appreciation.
But managing equity investments isn’t child’s play. One argument is to buy shares of different companies from different industries and achieve diversification. So instead of investing $100,000 in shares of an IT company, spread out your investment by owning shares worth $25,000 each in pharmaceutical, banking, superstore chains, and an IT company.
Theoretically, this may result in a reduction of risk and a healthy diversified portfolio of equity investments. But not all risks are reduced in this way. You still face market risks (also called systematic risk) that a country faces due to its political, social, and financial environment.
Because a country operates in a worldwide, interconnected economy, we should also add the risk of global impact and geopolitical risks. So, if you invest in shares of a company with 100% of the operations limited to a country, it may still face global risks. A good example is a local hotel chain impacted due to a pandemic, or a company’s supply chain being disrupted due to war or interstate conflict.
Cryptocurrency Investments
With ever-increasing institutional market players entering the world of cryptocurrency, the typical relationship between risk and reward becomes super complex to describe. While learning about how to be a smart crypto investor, the real-time market data might have taken a different, unique shape. Such is the speed of this emerging digital market. You need to take off the “equity-thinking hat” to understand ins and outs of crypto risks and rewards.
Let’s take a quick look at how crypto investment is unique from its equity counterpart:
- Length of the industry: First formal stock exchange dates back to almost two centuries while crypto is a decade-old concept. While we have several equity experts, claiming oneself to be a crypto expert can be an oxymoron.
- Regulations: Our predecessors made mistakes and consequently we have devised a helpful regulatory framework to apply to stock exchanges. Introducing the concepts of market caps, floors, and investment disclosures ensures sudden losses are minimized. The Crypto industry is still in its infancy so better be prepared for surprises.
- Physical presence: Although you can invest in any stock exchange globally, companies, industries, and markets are still largely physical and confined to a country. There is a blurred line when it comes to defining crypto as physical or virtual.
What is Your Risk Appetite?
Your tolerance level to take a risk and soak losses is the risk appetite. If you are already a well-accomplished investor, you have a higher risk appetite and might be tempted to take higher risks to get higher rewards. Conversely, suffering a loss is something a person with a low or moderate level of risk appetite will always avoid.
Take a look at the graph below, comparing yields from three different investment options for the year 2020:
Source: Newsbtc
A brief takeaway from the graph above:
- Stocks yield a comparatively lower return accompanied by a lower level of risks. The performance has been consistent except for one ugly dip.
- Bitcoin topped with a good return but with a much higher risk. Don’t be fooled by taking the final picture of a 90% yield. Several sharp declines mean investors with a very high-risk appetite can afford to keep their investments untouched throughout the year.
- Gold depicts a moderate, decent-looking return with lower risk and no significant dip.
What is the Low-Risk High-Return Option?
Less risk-loving investors may want to consider investing in some form of precious metals as a portfolio diversification tool. The benefits of a more stress-free life, with fewer sleepless nights, are more commonly shared by precious metals investors, with holdings in silver and gold, than those primarily involved in crypto and stocks.
If you feel that you still need more information, I recommend learning more about precious metal investing to discover alternative investment options, including gold. These assets present fewer systemic risks, less uncertainty, and significantly less volatility.
Whatever investment option you decide on, make sure it complements your risk tolerance and doesn’t present any risks to your portfolio that you cannot afford to take.
Mustafa K. (CA, CIA) is an accounting professional with over a decade of experience in financial audits, compliance, and advisory. Currently, Mustafa serves as a tax associate and finance writer.
