When most people think of the stock market phrases come to mind like “It’s too risky”, “I’ll lose money” or “I’ll become rich.” If you are wondering if you should invest your money in the stock market or just play it safe and put it in the bank, it is important that you understand the potential risk reward relationship of investing.
It is true that investing in the stock market will expose you to various risks. For most, the main concern is investment risk, which simply put is the risk of losing money. Although market fluctuations can trigger losses, there are ways to mitigate this risk. When investing in the stock market, it is important to evaluate your tolerance for risk. In other words, how much can you stomach? This will help you to determine the appropriate asset allocation for your investments. For example, if you do not mind taking risk and understand there will be market fluctuations, you may have a portfolio with a higher concentration in stock. On the other hand, if you’d rather minimize risk, you may have a portfolio more concentrated in bonds and cash equivalents.
With that being said, it is important to understand the relationship between risk and return. The higher the expected risk, the higher the expected return. This is also the case in reverse where the lower the expected risk, the lower the expected return. Typically, short term investments such as cash and CDs yield lower returns because they are not exposed to market risk. Although the stock market will expose you to more risk as compared to these investments, the potential for a higher return is greater.
It is also important to understand the impact that time has on the return from investments. When investing in the stock market, you should typically have a long term time horizon which historically reduces the downside that comes with market fluctuations. When comparing longer investment periods to shorter periods, the risk for loss is reduced over longer periods.
There are various asset classes and sectors in the stock market. Risk tolerance and time horizon are factors in determining what types of assets are most suitable for you as an investor. Asset allocation and diversification are investment strategies that can reduce investment risk over time. In addition, other strategies such as dollar cost averaging also help to reduce risk.
When understanding the associated risk and potential return from investing in the stock market, you can make an informed decision as an investor. Since the performance of the stock market has historically outpaced inflation, it can provide a wonderful opportunity for growth which will help you to achieve your financial goals.
The idea of investing in the stock market can be exciting, scary or even overwhelming. Once you have a better understanding of how the stock market works, you can make an informed decision about the allocation of your investments.
