From low to high: Understanding risk in investing

Everyone who has ever put their money into an asset in hopes of generating profit knows that risk is an integral and necessary feature of investing. You simply can’t have one without the other because risk is directly correlated with returns, in that generally, low-risk investments are associated with lower potential returns, while high-risk investments have the potential to bring in more substantial earnings. 

It’s the same in life. If you want to achieve something, you must be willing to take some risks; otherwise, you’ll hardly make any progress. Although you can’t avoid risk altogether, you can certainly choose how much risk you’re comfortable with, depending on your financial goals and risk tolerance, since not all investments are created equal in this respect. For example, crypto is considered a risky investment due to its high volatility. As data shows, the Bitcoin and Ethereum price USD can fluctuate wildly, so investing in digital assets like Bitcoin and Ethereum might not be for the faint of heart. 

But how much risk is too much – or how little is too little – and how should investors go about assessing and managing risk? These are some of the aspects you should clarify if you intend to put your money to work and increase your returns without compromising your financial safety. 

What is risk? 

In finance, risk refers to the probability of an investment outcome to differ from the initial expectations. In other words, it describes the level of uncertainty and exposure to potential loss related to different types of investments. 

Every market and investment product comes with a specific risk and payoff profile. Based on this characteristic, investors can gain an idea of how easy it’s going to be to access their funds, how long it’s going to take before the investment starts paying off or how safe their money is. Analyzing these features can help individuals decide how much risk they’re comfortable with when investing and make more informed decisions. 

Measuring risks 

It’s extremely important to be aware of risks before you invest your money in a certain asset. You don’t want to walk into it blindly, hoping you’re going to make a huge profit only to see your hopes shatter and your funds vanish in one fell swoop. 

But how do you know how risky or safe an investment truly is? Although there’s a lot of talk about risk management in finance, there is no measuring system that could help one determine the level of risk that an investment instrument carries with absolute accuracy. As strange as it may seem, viewpoints and approaches on the topic vary widely and the lack of consensus creates a lot of confusion, especially among beginner investors who are surprised to find out that measuring risk is not a clear-cut, black-and-white matter as they expected. 

Many researchers use volatility as a way to quantify risks, which makes perfect sense given that volatility reflects how quickly the value of an asset changes over time and can therefore indicate how that asset is going to perform in the future and how likely it is to lead to gains or, on the contrary, losses. Volatility is also a metric that’s closely monitored by financial analysts and can be gauged relatively easily.   

However, volatility and risk are not perfect synonyms and one cannot equate one with the other. Although there is some overlap between the two and more volatile assets expand the range of expected outcomes, it does not change how that asset is going to perform. So, even if one might find it difficult to predict potential movements for an investment vehicle, it doesn’t necessarily mean they are exposed to more risk. 

Despite the difficulty of making precise assessments, there are certain factors one should look at to get an as accurate idea as possible about an investments’ risk. The best way to go about it is to take into account historical data and analyze past patterns and behaviors. Obviously, past performance is not a foolproof predictor of future performance, but it does provide an insight into how the studied products might progress.  

Research in this field identifies several strategies and tactics that are commonly used to examine risks, such as standard deviation, beta, Value at Risk (VaR), and the Capital Asset Pricing Model (CAPM). 

Low-risk investments

Less risky investments give holders the possibility to build their wealth gradually, while reducing the chance of loss. This can mean limiting the amount of money invested into a certain asset class or the impact it might have on their portfolio. Evidently, with lower risk, investors may have lower gains, so it’s a trade-off one needs to keep in mind.  

The advantage of investing in low-risk assets is that it gives investors the opportunity not only to minimize potential losses but also to ensure that these losses won’t jeopardize their investment endeavors. As a result, low-risk investments are better suited for risk-averse participants or novice investors who are less experienced in the world of finance. Options include Treasury bills, notes, bonds and TIPS, corporate bonds, money market funds, fixed annuities, dividend-paying stocks, etc. 

High-risk investments 

When it comes to high-risk investments, one should expect a higher likelihood of capital loss, a more pronounced probability of underperformance, or losses that could lead to irreparable damages to one’s portfolio. On the upside, these types of investments can also offer a higher return rate, which is something that risk prone investors appreciate. 

Some of the most popular investment vehicles that fall in this category include initial public offerings (IPOs), cryptocurrencies, high-yield bonds, real estate investment trusts (REITs), and others. 

Specialists recommend portfolio diversification as the best method to keep investment risk in check and ensure long-term success. This implies spreading your funds across a variety of assets with different risk profiles, so that a bad event or a poor performing product doesn’t have a major impact on the overall health of your portfolio. Therefore, combining both low- and high-risk investments and maintaining a good balance between the two is the surest and safest way to ensure positive outcomes in the long run. 

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