How To Win At Investing: Understanding The Balance Of Risk And Return

Grasping the link between risk and return is vital for savvy investing. Personally, I’ve invested in a lot of different things over the years, from crypto to real estate to art to mutual funds. Some investments are sexier than others, sure, but in an ideal world, each one works together with the others in my overall portfolio to create both diversification and a balance of risk and return.

In other words, I have some investments in my portfolio based on very stable assets. The returns are predictable, and I don’t lose any sleep over these investments. There’s not much I can gain from them, but since they have a low investment risk, there’s also not much I will lose either. Some of you may recognise this as modern portfolio theory. For those who haven’t heard of it, fear not; we will discuss it later in the blog.

On the other hand, some of my portfolio is invested into much more speculative and higher risk investments, like crypto and startups. These are investments that elevate one’s heart rate (if indeed a financial instrument could do such a thing). There’s a higher risk-return tradeoff, but there’s also a more-than-likely chance that I could lose some or all of my investment. How you chose to invest ultimately comes down to your risk tolerance.

Losing money in investing is never fun, but it’s par for the course when you want the chance to get substantial returns in a short amount of time. The key, of course, is to ensure that you fully understand the risk of each investment, including systematic risk, so that you can go in with your eyes wide open, and also to ensure that you maintain a balanced risk-reward ratio throughout your overall portfolio.

In this article, we’ll cut through complexity to answer the pivotal question: How can you manage risk while pursuing the best possible returns? Expect to gain insights on shaping a risk-aware strategy to enhance your investment outcomes.

Key Takeaways

  • The inherent relationship between risk and return in investments dictates that higher risks often correlate with higher potential returns, necessitating a thorough understanding of the associated risks such as market and systematic risk, which influence investment decisions.

  • Diversification is a key strategy for mitigating risk, involving investment across various asset classes and markets, and is supported by tools such as mutual funds and ETFs; additionally, matching an investor’s risk tolerance with the appropriate asset allocation is critical for balancing risk and achieving financial goals.

  • Several strategies are employed to manage risk and maximize returns, including adjusting asset allocation according to goals and risk tolerance, considering tax implications, applying Modern portfolio theory, and using the Sharpe ratio for assessing investment returns against risk taken.

  • Specific strategies that Goodegg Investments takes to mitigate risk in every investment opportunity we take on.

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The Connection Between Risk and Return

In the world of investing, risk and return go hand in hand. The core principle is that higher risks typically offer the potential for higher returns, but also pose greater chances of loss. This balancing act of risk and return plays out across the entire spectrum of investment options, from low-risk government bonds to high-risk equity and commodity contracts. Understanding the risk-reward ratio is crucial for making informed investment decisions.

Startups or volatile commodities are considered investments with a high investment risk, but, offer the potential for substantial returns. However, they also come with increased volatility and a greater chance for total loss. Investors, therefore, expect that the relationship between more investment risk and higher returns will be consistent across their risky investments choices, taking into account the higher risk involved.

Market Risk

Market risk is an inherent part of investing. It refers to the potential for investors to experience losses due to factors that affect the overall performance of entire financial markets or segments (systematic risk). For instance, changes in economic indicators, geopolitical events, or shifts in investor sentiment can all trigger market-wide effects.

One key strategy to mitigate market risk is diversification. By spreading investments across different asset classes such as stocks, bonds, and cash, investors can shield their portfolios from the full brunt of market fluctuations. This is because these asset classes typically do not respond uniformly to market conditions. Hence, even if one asset class performs poorly, others might perform well, thus providing a degree of protection against market risk.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) offers crucial insights into the intricate relationship between risk and return. This financial model posits that the expected return on an investment combines the risk-free rate and a risk premium. Simply put, CAPM helps you understand how much extra return you might expect, given the additional risk you onboard. 

Incorporating CAPM into your investment strategy enables you to estimate expected returns more accurately based on an investment’s risk level. This aids in making better-informed decisions about which assets to include in your portfolio, balancing risk and return effectively. Moreover, CAPM emphasizes the value of diversification, reminding us that while some risks cannot be diversified away, managing and understanding these inherent risks can pave the way for more strategic investments.

Systematic Risk

Systematic risk, also known as undiversifiable risk, is another crucial component of investment risk. It’s the inherent risk in the market that impacts the entire market or a specific market segment and arises from broad economic, geopolitical, or financial factors. This risk cannot be completely eliminated through diversification. However, it can be managed using hedging or the correct asset allocation strategy.

Events such as interest rate changes, inflation, recessions, and wars contribute to systematic risk by affecting the entire market. Asset allocation across various asset classes such as fixed income, cash, and real estate can help investors manage the impact of systematic risk. The beta of an investment is a measure of its volatility in comparison to the market and indicates the level of systematic risk involved. A beta greater than one suggests the investment has more systematic risk than the market, while a beta less than one indicates less systematic risk.

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Assessing Investment Risk

Assessing investment risk is a crucial part of not only the investment process but also your financial planning. It involves using metrics like Standard Deviation, along with risk-adjusted metrics such as the Sharpe ratio or the Information ratio. It is important to compare these metrics against a peer group average or a specific market index. This will help in conducting effective risk assessments..

A higher standard deviation implies a higher level of investment volatility. As a result, it also indicates an increased level of investment risk. Risk-adjusted performance metrics like the Roy’s safety-first criterion, the Sharpe ratio, alpha, beta, and R-squared are methods used to analyze and quantify the balance between risk and return. Alpha indicates performance relative to a benchmark, while beta indicates volatility in relation to the market.

In the realm of investment, risk is often expressed as a percentage to estimate potential loss. For instance, a 25% risk of loss indicates an expectation that one out of four investors may lose money on that investment. When assessing overall risk, you’ll need to take into account the balance of risk and potential return.

Related: Watch What Happens When You Invest $50k Per Year In Real Estate Syndications

Diversifying Your Investment Portfolio

Diversification plays a pivotal role in financial management of you portfolio. It involves spreading investments across various assets within an asset class to mitigate the effects of market fluctuations and decrease single-security risk. This strategy can reduce risk while potentially maintaining or amplifying returns.

Achieving a balance of risk and returns in a portfolio can be accomplished by diversifying across asset classes with low correlation to each other. Investment vehicles like mutual funds can aid in this process. Effective diversification entails investing in a variety of sub-asset classes and extending investments to both domestic and international markets. This spreads risk across economies and currencies, taking advantage of sectoral and market-based performance differences.

Mutual funds, including the popular mutual fund option, and exchange-traded funds (ETFs) provide accessible means of achieving diversification, allowing investors to engage in a broad range of underlying investments without requiring large sums of capital.

Risk Tolerance And Financial Goals

Every investor has a unique level of risk tolerance, which is the ability and willingness to endure declines in the value of investments. This tolerance is critical in deciding how to invest. It’s influenced by factors like:

  • retirement time horizon

  • portfolio size

  • future earnings potential

  • the presence of other assets

  • investment objectives

  • reaction to market losses

  • level of investment experience

If you have a moderate risk tolerance, you might adopt a balanced approach, investing in stocks for growth and bonds for stable income. This aligns investments with financial goals, emotional resilience, and knowledge level, determining the appropriate asset allocation. Additionally, considering the risk-reward ratio can help you weigh potential returns against the associated risks, ensuring your investments are well-suited to your tolerance levels.

Financial advisors can often play a pivotal role in this process. They can help you develop a personalized financial plan that takes into account your risk tolerance and financial objectives. They advise on investment, savings, budget, insurance, and tax strategies.

Related: What To Do With $100k In Cash – Saving Vs. Investing In Real Estate

Check Out Our Track Record Of Success

Curious whether we can actually do what we say we're going to do? Compare projected versus actual returns in all the deals we've exited to date.

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Strategies For Managing Risk And Maximizing Returns

Managing risk and maximizing returns is a delicate balancing act that involves several strategies. One such strategy is adjusting asset allocation, which involves distributing investments across various categories matching an individual’s financial goals and risk tolerance. Incorporating asset classes like:

  • stocks

  • bonds

  • cash equivalents

  • real estate

  • alternatives

Investing in a diverse portfolio, including other investments, enhances diversification and potentially stabilizes your risk-return tradeoff.

In making asset allocation decisions, considering the tax implications can improve the after-tax return of investments. The Modern portfolio theory seeks an efficient frontier, aiming for the lowest risk for a given rate of return through statistical techniques. Minimizing the impact of any single economic event on a portfolio is achievable by investing in different industries and sectors.

The Sharpe ratio is used to discover if an investment’s return is due to smart investing or excess risk by comparing with the risk-free rate. Dollar-cost averaging reduces risk over time by consistently investing a fixed amount, leveraging the fluctuation of investment prices. Regularly rebalancing the portfolio to align with the target asset allocation maintains the investment’s consistency with an investor’s goals and risk profile.

Interest Rates And Their Impact On Risk And Return

Interest rates are a major factor impacting investment risk and return, including interest rate risk. The Federal Reserve’s modifications to the federal funds rate can result in immediate stock market responses. Higher interest rates might lead to decreased earnings for companies and subsequently lower stock prices, except for the financial sector that could gain from rate increases.

Interest rates and bond prices have an inverse relationship. As interest rates go up, bond prices tend to drop, prompting investors to transition from stocks to bonds for potentially lower risk and more stable prices.

Lowered interest rates make loans cheaper, encouraging spending and potentially raising asset prices. The expectation of rate changes can alter consumption and spending habits even before any actual adjustments take place, reflecting the impact of monetary policy on economic confidence and decision-making.

High-Risk Vs. Low-Risk Investments

Investments vary greatly in their risk profiles. Investors with a conservative risk tolerance prioritize capital preservation and tend to select low-risk investments to avoid significant value fluctuations. On the other hand, investors with an aggressive risk tolerance lean towards mid to high-risk investments, such as stocks and real estate, for the possibility of higher returns over time, despite the risk of losing the principal.

While high-risk investments have the potential for higher returns, they also carry the risk of capital loss and may not always fulfill their promise of high returns. Low-risk investments like insured money market accounts typically yield returns just above inflation rates, leading possibly to a negative real return.

Related: How To Invest $10k, $25k, Or $50k In Real Estate

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Real-World Examples Of Risk And Return Trade-offs

In the real world, investments vary greatly in their risk and return profiles. For instance, investing an initial investment in a high-risk startup can potentially lead to a complete loss or substantial gain. On the other hand, a particular investment in blue-chip stocks from large, well-established companies offers more stability with modest returns.

These real-world examples illustrate a clear risk and return trade-off. Stocks of large, well-established companies usually have less price volatility compared to those of smaller or newer companies, affecting their risk and return balance.

Related: Dollar-Cost Averaging In Real Estate

The Role Of Financial Experts In Managing Risk And Return

Financial experts play a pivotal role in managing risk and return. They can assist in:

  • Developing a personalized asset allocation strategy that fits an individual’s unique circumstances and goals

  • Conducting regular assessments to re-evaluate client situations and adjust financial plans accordingly

  • Maintaining a focus on the client’s long-term objectives

While investing, knowledge is power. Financial advisors provide the following services to their clients:

  • Educate clients on financial matters to facilitate informed decision-making and enhance their understanding of complex financial concepts

  • Provide ongoing portfolio monitoring

  • Regular updates to the client to ensure alignment with financial goals and responsiveness to any significant life changes

How Goodegg Mitigates Risk In Our Investments

Here are Goodegg, we’re always cognizant of the risks in every investment we make. We also take the responsibility of protecting our investors’ capital very seriously. As such, we do everything we can to offset the balance of risk / return in our investments.

In other words, we put into place multiple strategies to ensure that the level of risk is as low as possible, while still maintaining a strong potential for investor returns.

Here are a few ways that we do this:

  • We only invest in assets that cash-flow as is. That means that, even if we don’t do anything to the asset, it can still cover all expenses on its own.
  • We underwrite every deal conservatively, with conservative growth numbers while maintaining a buffer for unexpected expenses.
  • We ensure that we have strong reserves for each asset we invest in (as “just-in-case” fund, if you will).
  • We run multiple stress tests for every deal, seeing the impact of various factors and changes that could happen, so that we have a full understanding of the worst case scenario.
  • We ensure that everyone leading the investment has a strong background of experience, and a proven track record.
  • Whenever possible, we invest in assets that have a proven path to returns. For example, a multifamily asset that has already renovated a portion of the units and are achieving market rate rents. This tells us that the business plan we’re thinking of is very likely to work, and thus achieve projected investor returns.

Summary

Understanding the balance of risk and return is crucial to investment success. This involves financial planning, assessing risk, diversifying investments, understanding your risk tolerance, and incorporating strategies to manage risk and maximize returns.

It’s also important to understand the impact of interest rates on your investments and to differentiate between high-risk and low-risk investments. Finally, seeking the guidance of financial experts can provide essential insights and strategies for managing risk and maximizing return on investments.

Check Out Our Open Investments

Want to invest alongside us? Take a look at some of our current and upcoming offerings.

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Frequently Asked Questions

What is the relationship between risk and return in investing?

The relationship between risk and return in investing is that higher risks usually come with the potential for higher returns, but also carry a greater chance of loss. This applies to all types of investments.

What is market risk and how can it be mitigated?

To mitigate market risk, diversify your investments across different asset classes to minimize potential losses due to factors affecting overall market performance.

Why is diversification important in managing investment risk?

Diversification is important in managing investment risk because it helps to reduce the impact of market fluctuations and decrease the risk associated with individual securities, ultimately lowering overall risk while potentially maintaining or increasing returns.

How do interest rates impact investment risk and return?

Interest rates can impact the value of investments by influencing company earnings and stock prices. Higher rates may lead to decreased earnings for companies and lower stock prices, while lower rates can encourage spending and raise asset prices.

What is the role of financial experts in managing risk and return?

Financial experts play a crucial role in managing risk and return by developing personalized asset allocation strategies, educating clients on financial matters, and providing ongoing portfolio monitoring and updates to ensure alignment with their financial goals.

Check Out Our Track Record Of Success

Curious whether we can actually do what we say we're going to do? Compare projected versus actual returns in all the deals we've exited to date.

download track record

 

Next Investing Steps

Whether you’re considering investing in stocks, startups, real estate syndications, or a combination thereof, we’re here to support you in fully understanding the relationship between risk and return.

As you continue to explore different investments and which ones might be right for you and your appetite for risk, we’re here to help! 

As a first step, we invite you to join the Goodegg Investor Club, so we can keep you in the loop on insights, as well as opportunities to invest alongside us in real estate syndications, if that’s the right fit for you.

You can also check out our open deals page to learn more about our current or upcoming opportunities.

Learn More

If you’re not yet ready to invest but are curious about how all of this works, we invite you to dip your toe in the water with us through our free 7-day email course – Passive Real Estate Investing 101

You can also get a copy of our book – Investing For Good – or check out our Life & Money Show Podcast.

To learn more about us and our experience, be sure to download a copy of our track record, which shows the projected and actual returns we’ve achieved across all the deals we’ve exited to date.

Connect With Us

If there’s ever anything we can do to help you on your journey, feel free to email us at [email protected] or call / text us at (888) 830-1450

Want To Invest With Us?

You're invited! Join the Goodegg Investor Club to get access to our open investments and to stay in the loop on upcoming opportunities.

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