Day 13 - Risk Reward Tradeoff

A refrigerator is a device to keep food fresh, but it cannot do so forever. Over time food inside the fridge becomes stale or dry and inedible.

Similarly, a bank is a place to keep your money safe, but then the money you save in a bank loses value over time because it cannot keep up with inflation. 

Investing is the only known antidote to inflation. It also helps you grow wealth or generate passive income. 

But investing can be volatile and risky.

What is Investment Risk?

Risk is the likelihood of losing money and not having the opportunity to recover it.

It typically happens due to unexpected reasons or bad investment decisions. (CFD/Margin Trading, Ponzi Schemes, Bankruptcy, geo-political events/sanctions, Government actions, etc.)

What is Volatility?

Volatility is the fluctuation in the market price of an asset. The values go up during favorable conditions, and they go down during adverse conditions.

Difference between Risk and Volatility 

1. Risk is permanent, and volatility is usually temporary. 
2. Investment risk increases with time, while volatility typically decreases with time. 
3. Your investment volatility can become a permanent loss if you liquidate it when the value is down.
4. Waiting for the markets to recover can help you avoid losses and increases the chances of growing wealth. 

Risk and volatility are inherent in investing and cannot be avoided altogether.

Investors must make decisions based on the risk/reward tradeoff.

What is Risk-Return Tradeoff?

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Risk and returns go hand in hand. Your potential to generate higher returns typically increases with your ability to tolerate higher risk.

The mental bargain you make with risk to generate desired returns is known as the Risk-return tradeoff.

You can achieve an ideal risk-reward ratio by using the following strategies;

1. Goal-based investing 
2. Prudent Asset Allocation
3. Regular Review and Rebalancing

We will learn more about these strategies in the following days.

See you tomorrow.