Understand How Risk and Return are Related
Yes, risk taking is error prone, otherwise it would be called sure thing taking.
— Jim McMahon, Football Player
Imagine you are a competitive diver in the Olympics. You will be judged on your form, your technique, and the difficulty of your dives. The more complicated a dive, the higher your potential score. But also, the higher the chances of not executing the dive perfectly and getting a lower score.
Investing is similar. The more risk you take on in your portfolio, the greater your expected return potential. Academic research has shown that different stocks have different expected returns. For example, small company and value company stocks have greater expected returns — and risks — than growth and large company stocks.
Why? Let’s say you wanted to invest in a tech company. You narrow your options down to two. Joe’s Tech is a small company, newly listed on the stock exchange. They have a lot of innovative ideas and hope to become a great business. They also aren’t generating a profit yet and have substantial debt. The other company is the largest firm in the world — Apple. In 2018, they have strong financial statements, impressive sales, extensive research budgets, a strong product pipeline, and so on. If the returns of these stocks were expected to be the same, no one would invest in a lesser-known and riskier company like Joe’s Tech. The reason smaller companies can attract investors is because of their higher expected return (vs. an established company) if they achieve their ambitious goals. They might become the next Apple. They also might go out of business. This is the risk, but also the potential reward.