Tuesday, March 4, 2014

Basics of risk and return

Investing is a risky endeavor.  There is a real possibility of losing some of your hard earned cash.  But why bother?  Because there's a greater possibility of earning more cash in the long run, if you invest properly!

Suppose you have 4 investments all requiring $100 upfront and the outcome is determined by a flip of a coin.

#1:  Pays $130 on heads, $90 on tails.
#2: $220 on heads, nothing on tails.
#3: $110 on heads, nothing on tails.
#4: $220 on heads, $90 on tails.

#1 and #2 have the same expected return but #2 has a higher risk since there's the possibility of losing your entire $100.  So most people, being risk averse, will pick #1.  No sane person will pick #3 which has a negative expected return.  Many investments masquerade as something innoculous but are similar to #3..  fortunately, they can be uncovered with some due diligence and research.  More on that in a later post.  #4 has the highest expected return and the same risk as #1 but in reality, you will almost never find such an investment (or else we will all be millionaires.)  More on that in a later post too.

Bottom line is, investing requires money to make more money in the future, and money lost cannot be invested to generate income and capital gains for the future.  So it is important to determine your risk tolerance before you make the leap and invest.

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