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Analyzing how much risk an investor should take based on their goals and timeline.
If someone offered you a guaranteed 1,000, which would you take? Your answer reveals your 'risk tolerance,' the invisible force that determines whether you'll end up a millionaire or broke.
In the world of finance, there is no such thing as a 'free lunch.' This leads us to the Risk-Return Tradeoff: the principle that potential return rises at the cost of increased risk. Think of it like a seesaw. If you want the 'high' of a big profit, you must be willing to sit through the 'low' of a potential loss. Low-risk investments, like a Savings Account, offer safety but very small returns. High-risk investments, like Individual Stocks or Cryptocurrency, offer the chance for massive gains but could also drop to zero. Mathematically, we can think of the expected return as being positively correlated with the variance or risk of that investment.
1. Investor A puts 2\%1,000 \times 1.02 = . 2. Investor B puts 2,000 return, but faces the possibility of having $0.
Quick Check
If an investment advertisement promises a 50% annual return with 'zero risk,' why is this likely a scam?
Answer
Because the Risk-Return Tradeoff dictates that high returns must be accompanied by high risk; 'guaranteed' high returns violate basic economic principles.
Let's calculate if you are actually getting richer: 1. You put money in a 'safe' Certificate of Deposit (CD) earning a Nominal Return of . 2. The cost of groceries and gas (Inflation) rises by that year. 3. Calculate Real Return: . 4. Conclusion: Even though your bank balance went up, you can actually buy less than you could a year ago. You avoided Market Risk but lost to Inflation Risk.
Quick Check
Which type of risk are you taking if you keep all your lunch money in a shoebox under your bed for five years?
Answer
Inflation Risk (the money stays the same amount, but prices for lunch will likely rise, making your money less valuable).
Compare a 20-year-old student to a 70-year-old retiree: 1. Student (Age 20): . They should put in stocks and in bonds. They want growth! 2. Retiree (Age 70): . They should put only in stocks and in bonds. They want to protect what they have. 3. Scenario: If the stock market drops , the student has 40 years to wait for it to bounce back. The retiree needs that money for rent next month, so they can't afford the drop.
If an investor has a 'high risk tolerance,' which of these are they most likely to invest in?
Using the 'Rule of 100,' what percentage of a 15-year-old's portfolio should be in stocks?
If your investment earns 3% interest and inflation is 3%, your 'Real Return' is 0%.
Review Tomorrow
Tomorrow morning, try to explain the 'Rule of 100' to a friend and calculate the stock percentage for someone who is 45 years old.
Practice Activity
Look up the current 'Inflation Rate' online. Then, find the interest rate of a standard savings account at a big bank. Subtract the inflation from the interest to see the 'Real Return' of that account.