Risks and rewards are related. They are usually inversely related. Generally, the more risk you take, the more you can get in reward. The opposite is true too though; the more risk you take, the more you can lose! Therefore, the risks you take should be calculated based on various factors.
For the most part, we’ll stick to personal financial risk. Components when assessing your financial risk (i.e., how you plan to save and spend your money) may include the following:
- Household income
- Income stability
- Income streams
- Current investments
- Current lifestyle
- Future estimated cash flows
- Future lifestyle expectations
You may have seen or heard questions around these components when completing a financial assessment questionnaire or speaking with a personal financial advisor. It’s for them to learn about you and see what financial products suit your personality and risk tolerance.
Traditionally, your risk level would need to be adjusted or lessened as you grow in age and as your ability to work lessens. The risk would be adjusted by rebalancing your accounts into safer investment options.
Risks of Investing In Different Types of Funds
Many people know that I am a proponent of low-cost index funds. They can tailor to any kind of investor, reduce risk in one simple step via diversification and are just as easy to get in and out of as stocks (even though I don’t frequently trade them as I’m more of a buy and hold investor).
Anyway, let’s simply compare the performance metrics of two popular Vanguard Funds: Total Bond Market ETF (BND) and Growth ETF (VUG) to see how risk plays a role in reward.
For BND, Vanguard assigns a risk level of 2 – “conservative to moderate”
For VUG, Vanguard assigns a risk level of 4 – “moderate to aggressive”
According to Vanguard, the performance for these two funds is as follows:
It’s simply clear to see that VUG performs better. But at the same time, it is more volatile than BND. So you have to be able to stomach the volatility. In other words, you need to be ok with your money-losing and increasing in value frequently and dramatically. The chart below shows a picture of this:
From the chart above, obtained from Vanguard you can see that in 10 years, $10,000 can grow to about $15,000 if invested with BND. And you can see that $10,000 can grow to about $40,000 if invested with VUG. One fund offers a smooth ride, and the other offers a bumpy one (as depicted by my perfect red circles which note areas volatility within the fund).
Life’s Risk Reward Relationships
This applies not to investing, but in other parts of life. As I mentioned earlier, the risk should be calculated and offset with other factors. Here are a couple of simple examples:
- Career Risk: Your boss asks for a volunteer for a complex and high profile assignment. You know that if you execute it well, it would include visibility in the organization and a high chance for a raise or promotion. However, if you don’t perform well or something goes wrong, you will be in the hot seat and may lose trust and goodwill. You can offset this risk by taking time at and away from work to learn more about the deliverables of the assignment, break it up into manageable pieces, and formulate a plan to ensure the assignment is completed and meets or rather, exceeds expectations.
- Health Risk: You’re eating cheeseburgers every day. You may be at risk for a heart attack caused by greasy food and clogged arteries. You can offset this by eating other healthy foods like whole fruits and vegetables. You can also offset the risk of a heart attack by exercising regularly with a combination of cardio and weight training.
- Relationship Risk: You’re in a marriage and only hang out with your friends and only come home after work or to go to bed (i.e. not spending any time with your spouse). You may be at risk of a divorce caused by a lack of communication, attention, affection, etc. You can offset this risk by balancing the time spent with your friends and your spouse. You can also offset this risk by including your spouse in time spent with friends.
The Risk of Not Taking Risks
Toggling back to personal finance, the risk of not taking risk is that the performance of your portfolio may not be keeping up with inflation. In other words, you may not have enough money saved up once you totally stop working to pay for the rest of your life.
According to the U.S. Bureau of Labor and Statistics, an item that costs $5 in 2000 costs $6.45 in 2019; an increase of about 29%. This is why it’s important to take risks when you are young; to put yourself finances in a position so they are able to beat prices of goods and services over time caused by inflation.
You have more of a key element when you’re young: Time. This is why time in the market is better than timing the market. By accepting investments with some risk, the natural cycles of the market, and the power of compound interest all, afforded via time, you can position yourself with investment success.
Join The Discussion:
- How do you keep calm with stock market volatility?
- What financial risks have paid off and not paid off for you?
I use Personal Capital because (1) it’s free, (2) it tracks all of my accounts and overall net worth, (3) my account balances automatically update, (4) it shows how my investments are diversified and allocated in various sectors, and (5) can use built-in tools like “Investment Checkup” to get….wait for it…free personalized advice!
Check out my simple, yet detailed Personal Capital Review here.