Video Transcript: Risk and Reward
Hello, welcome back. In this video, we're going to discuss risk and reward. So, for every risk that we take on financially, there is a reward for this risk, right? So, for the greater the risk, the greater reward we're going to want to receive in return. Okay, so let's look at a $1,000 investment, right. Our investment is the capital that we are risking, right. So we're putting up our investment of $1,000 in hopes that we will return some reward based on our amount of risk taken in the market, so with every investment that we make, there is a certain level of risk that we may either lose all or part of the investment, right, so we want to run through some of the different risk mechanisms or investments that we can invest in, right, and talk about their, their risk and reward basis, right. So first we'll look at an FDIC insured savings account, right. So the Federal Reserve has created this federal deposit insurance right for all Americans, or anybody that has a checking account, right, or any account that up to $250,000 The Federal Reserve and the US Treasury will insure that money up to $250,000 right? So we have an insured savings account, right? So the risk for that, because it is insured and we're only risking $1,000 or making that investment, right? It's well under the $250,000 threshold set forth by the Federal Reserve. Okay, our reward for taking on that zero risk, because it's zero risk. Why? Because it's insured by the Federal Reserve. So, therefore, our reward will be very minimal at 1% Notice our yield on this risk on $1,000 is $1,010 or 1% of $1,000 so very zero risk, no risk. We get a very minimal return, right? So now let's look at the next risk investment. So now we want to lend our cash to a reputable company. Okay, XYZ, they've been in business for 150 years, and they have a very strong balance sheet, and they're a dominant player in their market, and they have plenty of market share. So, they're a reputable company, right? So, we're going to, we want to lend the cash to somebody that we know that can pay us back right over time. We know that they are going to be able to pay us back, so our risk is very low, right. So we're going to buy their corporate bonds. We know that they're a reputable company. We know that they're a dominant player in their space. We know that they have a strong balance sheet, and they're able, they're going to be able to pay us back one way or another, right. So, because the risk is low, right, but greater than the risk of an FDIC insured savings account, right, because remember that money is insured, so it's zero risk. Our investment in the low risk firm right is going to yield us 6% Notice it's greater than the FDIC insured savings account, because the risk is zero. So, because the risk was zero, we had a 1% yield. Now, because the reputable company has got a little more risk, right. We are going to yield 6% on our investment. Now, notice, as the risk appetite increases, so does the reward for making that investment and risking your capital, right? So, the 6% right, is going to yield us $1,060 on our $1,000 investment. So now let's go look at the next potential investment opportunity. Okay, so your doctor friend, right, comes to you and says, "Hey, I need to borrow some money, right. Let me, let me borrow some money, or
come, or come invest in this opportunity that I have, and I'm trying to diversify my portfolio, and I'm going to create widgets, and I'm going to sell widgets on the market, but because I don't want to risk all of my capital, I want to raise a
little cash, so he looks over next door to you, and he says. Hey, man, invest $1,000 in my widget company, right? And you say, okay, great, that sounds good. I'll invest $1,000 in your widget company. You're a smart guy, you're a
doctor, you can probably sell these widgets too, right? All right, so now what is the risk of this doctor, right, your partner? Now, what is the risk that he may not be able to pay you back, right? He's not insured, he's not reputable, right? He may be a reputable person in the community, but his business idea and his business production is not reputable, because it's a brand new venture. How are we going to know that this guy's business idea selling widgets is going to succeed? Right, we're taking a high risk here, right. So now, so let's say the widget idea falls flat on its face. He doesn't sell any widgets, and I want my $1,000 back, because he's not selling any widgets, and he's not making any money, right? But in the meantime, let's say the doctor loses his job, now what, right? So now the risk is unlimited, right, because he may not be able to pay us back at all, right, and because you're not investing in a reputable company, right? The same bankruptcy laws probably will not apply, because he's not an LLC partner, right? He's, he's a sole proprietor with zero, with all the liability, right? He's got all the liability, right? So, but he's a doctor, right, and he's got a good income, so the chances that he loses his job are probably small, right. So, because the risk is greater than lending to the reputable company, right, buying their bonds, the reward goes up to 8% now, right, because it's a greater risk opportunity, right. So I'm going to yield $80 on my $1,000 investment, right, because I'm research, I'm receiving 8% The risk has increased, so therefore the reward is increasing. Okay, correlated to the amount of risk, right. So invest in the stock market. Okay, let's say annual return is guaranteed to us of 10% right? But what's the risk, right? You could lose your whole investment in the stock market, right? But a lot of times you can, you have the option to sell, even if you do lose some money, right? But because of the market volatility, we are going to be looking for a 10% return, because the stock market is more volatile, much more risky, right? We want a greater return due to the volatility or the price movements, right, in the stock market. Okay, the price swings is called volatility, right? As prices move up and down, we are going to want a greater return, because our liquidity or our cash is in the stock market, which is subject to many different headwinds or risks, right? So we want a greater return for the stock market. Okay, now for an even greater risk, right, your brother-in-law comes to you, he's got a money making scheme, right, and he wants you to invest your $1,000 right, but he's going to give you a 50% return on your $1,000 right, and ownership stake in the business, but what's the risk? I could lose everything, I could ruin my relationship, and my family could be in turmoil, right. So that's why
the reward for this risk is much greater, because your brother-in-law has this idea that we don't know what's going to work. So he says, "I'm going to give you an ownership stake, and I'm going to give you 50% return if you let me borrow the money, right? So you need to make decisions on investing based one on your risk appetite, which means how much risk can I undertake, right? How much risk am I willing to bear right to receive this reward, or this return, or this yield right on my money. So now we're going to graph the risk, just to show you how it kind of works, right? How just on an illustrative example, right? So risk and reward. Okay, so now vertical axis, horizontal axis, right. So our reward will be up here. Okay, our risk appetite, our risk level will be on the horizontal axis. Now notice at 1%, 6%, 8%, 10%, and 50%. Okay, now 1% is here, pretty pretty low relative risk right now at 6% We'll notice how. The risk is correlated with the return. Okay, so as our risk increases, our return or our reward will also increase, so they are positively correlated as the risk increases, so does the reward. Okay, so as consumers, as investors, as business owners, we need to understand the correlation between risk and reward. Okay, just because there's a nice reward, 50% with my brother-in-law's investment opportunity doesn't mean I'm going to make the 50% You need to weigh your options, balance them out, understand, make a rational decision as an investor consumer, as any kind of public entity to maximize your value and to ensure that you secure your initial investment, and don't give yourself much downside risk opportunity.