Risk is defined as the deviation of the actual outcome from one’s expectations. Risk is involved in every endeavour in life be it personal, professional or social.
From a financial perspective, the risk is the possibility that the real profits from a result or investment may differ from the expected result or return. The danger of having to lose all or some of one's initial investment is a risk. Risk and reward are two opposite sides of the same coin. Risk can not be completely eliminated from any investment.
Even investments like online mutual funds, which are considered safe, are not free from risk. The risk of these online mutual funds losing all of your investment might be low compared to other riskier instruments, but then so is their profit potential- this is called the risk-reward tradeoff.
Now that we understand the relationship between risk and reward, let us take a look at how this works in the stock market.
As we just saw in the case of online mutual funds, the same risk-reward tradeoff works in the stock market. An investor can not expect exponential returns without also accepting a risk of a similar magnitude.
The best risk-return tradeoff is determined by a number of criteria, including the individual's appetite for risk, the number of years till retirement, and the ability to replenish one’s lost assets. Time is also crucial in developing an investment strategy with the right risk and return levels.
An investor considers all these different factors while deciding the apt risk-reward tradeoff and in turn uses that tradeoff before investing their money in the stock market, deciding their appropriate portfolio- having a mix of lower-risk blue-chip stocks and higher-risk stocks with huge potential upside but also a decent chance of loss.
Considering one’s portfolio, the tradeoff might involve determining if the assets are excessively concentrated or diverse and whether the composition poses too much risk or lower-than-desired return potential. The prominent metrics for analysing portfolio volatility include standard deviation, alpha, beta, Sharpe ratio and R-squared etc. These same methods are not just used to make decisions about stock market portfolios but also investments like online mutual funds etc.
Considering market volatility and the inherent risk in the stock market, the risk of market failure and your investments losing you money will always be there, regardless of considering the risk tradeoff and curating a meticulous portfolio, but these techniques manage and lower the risk to an appropriate amount.
From all this, we can conclude that the stock market investment, just like all other types of investments like online mutual funds, bonds etc carries inherent risk with it. This risk can not be eliminated completely but can be in part managed by making use of appropriate risk evaluation techniques and curating a diverse portfolio and in part adjusted to match an investor’s goals, priorities and risk appetite.
But even still, with the risk comes an ample opportunity to earn rewards that the investors who are willing to take that risk can enjoy.
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