Risk vs Reward: How Should You Invest Your Money?
There are a million different ways you can make money these days! And Iāll admit, when Iām bored, sometimes Iāll try to come up with the ānext big thingā. But my story always plays out the same:
Iāll spend a few hours brainstorming my idea, then go to sleep confident Iāve found the next āSnuggieā, only to wake up in the morning and realize how stupid it really was. Iām glad Iāve never gone through with any of my harebrained schemes!
As humans, weāre prone to survivorship bias. We praise and point to the ones that āmadeĀ itā ā but neglect to look at all the other outcomes. If we did, what weād see is that for every Beanie Baby, Snuggie and Fidget Spinner, there were a thousand other āgreat ideasā that completely failed.
Trying to launch the next viral product is risky business. Luckily, risk vs reward tends to be directly proportional. The people who succeed at making the Snuggies of this world,Ā are usually handsomely rewarded.
What is Risk?
It should be easy to answer, but the question gets tougher the longer I think about it. Indeed, even the Wikipedia page for āRiskā branches off into a rabbit hole of sub-categories and pages.
The subject matter can be lengthy, but for our purposes, Iām going to define risk as ā the assigned qualitative or quantitative value of possible loss.
Sorry if the answerās a little convoluted, but I wanted to leave it that way because I honestly feel like āriskā is something that can be both objective and subjective, without being mutually exclusive.
The Classic Coin Flip
Let me try to explain with an example. Pretend we bet on a coin flipā¦
Heads: You win $1.Ā Tails: You Lose $1.
In this simple scenario, itās easy to calculate expected value (EV) and thus quantify your risk.
You have a 50% chance at winning $1, and a 50% chance of losing $1.
So your EV in this example is:Ā (.5 x $1) + (.5 x -$1) = $0.Ā
Thereās not much risk. If you played this game a million times, you would expect to come out even in the long run.
Most people know this intuitively. In fact, if I asked you to play this game with me for a thousand flips, you would probably disagree, solely because itād be a waste of your time.
But what if we switched the rules around so it was:
Heads: You win $5. Tails: You still only lose $1.Ā
Youād probably call off work to play this game with me all day!Ā And most likely youādĀ have a nice chunk of change by the end of a million flips.
But what if I had deep pockets? What if I was Bill Gates? And instead of $5 and $1, we played for everything you own.
Heads: I write you a check for 5x your assets. Tails: Youāre out on the streets.
Would you still play? Most people wouldnāt. (You might not make it past a single flip!) But if youāre the gambling type, maybe you would take a shot.
But just for illustrationās sake, letās change the rules one last time, so itās:
Heads: You win a billion dollars. Tails: You die.
Stupid rules right? No sane person would play that game!
Unlessā¦ you were an inmate on death row? Or maybe if you had some kind of terminal disease? Now maybe the gameās not looking too shabby.
The iterations are endless! But the point is ultimately this: behind most chance situations in life, thereās some level of both objective and subjective risk at play (quantitative and qualitative).
The trick is learning how to manage and navigate that risk effectively.
A Very Scientific Chart
So in order to better illustrate all the different ways we can balance risk vs reward in our portfolios.
When it comes to investing your money, you can choose any one of the four quadrants; or you can invest in the middle intersection of all 4 like many people tend to do.Ā Every investment you make has a chance of success or failure. Risk vs Reward.
The way I like to personally think of my investible money is very similar to our illustration with the coin. I try to come up with a rough EV calculation, and I ask myself the question: āIf I were to make this same investment a million times, what are my chances for success, and whatās the return I could expect for the risk I took?ā
So to get a better idea of how people are currently investing their money, letās look into some examples from each quadrant.
High Risk, Low Reward
Yeah, you might know a guy who knows a guy who won $100,000 from scratch-offs; but I promise that is the exception, not the norm. The common theme in this quadrant is NEGATIVE expected value over the long run. āWhat is most likely to happen if I played this game 1 million times?ā
SCRATCH OFF TICKETS.
This includes playing the lottery. There are tons of people who play lotto games of some sort every week. You might say: the tickets are only a few dollars a piece! Thereās no risk in that. But the truth is your expected value from playing such games are terrible. Your risk of losing the money you put is essentially guaranteed over the long run.
GAMES OF PURE CHANCE.
Thereās a reason why slot machines are a casinoās biggest moneymaker. Games of pure chance are heavily stacked against you. This includes most every game in a casino. Once again, high risk of losing the money you put in, with a low chance of a reward.
Thank God for the improvement on spam filters. 10 years ago, your email box would be filled daily from Nigerian princes who wanted to store a few million dollars in your bank account. The cons were so poorly crafted, very few people fell for them. But the sad thing is; scammers are getting more sophisticated, and people still fall for get-rich-quick schemes all the time. Please watch out for ANYONE who is telling you that you can become rich with little work or effort.
Low Risk, Low Reward
Defense is the name of the game in this quadrant. This is your grandmaās money advice. And while thereās nothing intrinsically wrong with using these investment vehicles, just know that you are taking lower returns in exchange for higher security of your principal investment.
Many people still practice this today. They have piggy banks, emergency jars, or shoeboxes stuffed with cash. And while you are not likely to lose that money (apart from burglary), you are guaranteed to slowly lose through inflation the longer you hold it.
Your traditional savings account is hardly any better than your mattress money. As of this writing (2017), the major banks are paying .01% on a standard savings account. That is not a typo. Even the best online savings accounts clock in at a whopping 1%. Which means while itās better than shoving your money under the bed, inflation is still eating away at you.
U.S. TREASURY BONDS.
I wrote about this briefly in my series on how to build wealth. U.S. Treasury bonds are secure investment vehicles. Theyāll only go sour if the U.S. Government goes belly up. But you pay for that security with tiny returns. Right now, 1-year bonds are offering you 1.19% on your money. Of course, if you donāt mind tying up your cash for 30 years, you can boost those earnings to 2.79%. (Roughly zero net gains after accounting for inflation.)
CDs & MONEY MARKETS.
Currently, the best money market rates are hovering at about ~1% interest. And bank CDs are not doing much better. You can shop around for the best rates, but youāll find them to be around 2% returns for letting the bank hold your cash for 5 years. Once again, about zero net gains after adjusting for inflation.
The Middle Area
Itās not pictured in my scientific chart, but I like to think of the middle area as water cooler investing. These are the asset classes you might overhear your coworker talking about during your lunch break. The majority of the public stick their money here.
GOLD & PRECIOUS METALS.
Now weāre getting a little better as far as potential returns go. While gold will not throw off any cash flow or dividends, it does tend to appreciate in value over time (deflationary asset). So how much can you expect to earn? Tough to say. But from 1968-2017, gold has appreciated on average 3.224% per year after adjusting for inflation.
Whether youāre invested in a fund or picking your own stocks, the vast majority of people are putting their retirement dollars into the stock market. So what kind of returns can you expect from placing your bets on the market? Since its inception in 1871 to now (2017) the S&P 500 has returned on average 2.2% a year after adjusting for inflation. That number jumps up to 6.78% if you reinvested your dividends along the way. Obviously, you should reinvest your dividends.
With technology improvements, money lending has become easier than ever before. It used to be that you had to take on substantial risk in order to hard money lend to someone. Nowadays, there are literally dozens of peer to peer lending platforms you can choose from. There is definitely a chance that you could lose your principal if the loan defaults ā but returns can vary anywhere from 5-10% after adjusting for inflation. The range is wide because there are so many different types of loans you can choose from, and varying risk levels associated.
INCOME PRODUCING REAL ESTATE.
The word āincome producingā is key here. Itās my firm belief that if your real estate does not produce a positive net cash-flow for you, you are speculating ā not investing. Real estate is an extremely powerful asset class, and admittedly my favorite. The only problem here is that now we are treading into waters where skill and knowledge are critical in achieving good results. Donāt listen to fund managers who tell you real estate only returns 3% per year, so itās worse than stocks. Thatās just flat out wrong. Theyāre giving you numbers based on appreciation, but skilled investorsĀ rarely buy hoping for appreciation. They look for cash flow, cap rates, and projected IRRs based on today. Real estate is entirely deal dependent.Ā Bad deals can have you upside down, but good deals can literally have cash on cash returns of 15% or more (without even including appreciation).Ā
High Risk, High Reward
In this quadrant, the potential returns are huge. But so is the downside risk. In order to achieve outsized gains, you will need to be a master at your craft. Skill is the common theme here. Men and women who are able to achieve success in this quadrant are often of high net worth.
TRADING. (STOCKS, OPTIONS, ETC)
Dreams of being the next Wolf of Wall Street? You might want to reconsider. Very few people make it. Itās just a sober reality that most traders fail. Even the pros have a hard time beating the market. According to a recent study, only 1 out of 20 professionally managed funds beat the S&P 500. It truly takes a certain kind of skill and psyche to be able to consistently outperform the market. No wonder the general advice is to just invest in a low-cost index fund!
Donāt believe the hype. Flipping homes is nothing like what you see on TV. Itās capital intensive, labor-intensive, and incredibly stressful. Not to mention, truly good deals with good spreads on after repair value are hard to come by! Contractors are notoriously unreliable, and even conservative budgets are typically underestimated. Many people lose money on their first flip, and never try again, but if you can succeed here, there is no doubt good money to be made.
I have no experience with angel investing. But if another blogger I very much respect is no longer doing it, there has to be a good reason why. Starting a business on your own is risky enough, but investing in another personās business can be even riskier. Most startups are going to fail. No oneās going to care about your money as much as you. For every early round investor who got lucky enough to angel into Airbnb or Uber, there are thousands of others who went belly up.
GAMES OF SKILL.
This includes poker, daily fantasy sports, golf, eSports, or any other game of skill where you are betting money vs. other people. The risk vs reward here is high, but the big difference between these games and games of pure chance is that you can have a direct effect on your outcome.Ā There are many professional poker players and professional DFS players, but I canāt think of any professional slot players.Ā Games of skill tend to be against other human beings, rather than a āhouseā or casino, so if you are more skilled than your opponents you will make money over the long run.
BITCOIN & OTHER CRYPTOCURRENCIES.
Bitcoin and crypto deserve an entire post for itself, and itās an area that I look forward to writing about in the future. Suffice it to say, that right now, itās one of the most hotly debated assets you could invest in. To most people, itās either the future of money or the next tulip bubble. Iām personally bullish on Bitcoin, but I admit that it could go to zero as easily as it could go sky high. If you invest here, be mentally prepared for a lot of volatility.
Low Risk, High Reward
The ever elusive, and mythological low-risk high upside investments. Do they even really exist?
Please let me know if you have any of these opportunities lying around. I think in reality they are few and far in between.Ā
SMALL BUSINESSES W/ LOW STARTUP COSTS.
In my opinion, launching a business with small start-up costs is a low-risk high reward proposition. Typically businesses that fall into this boat require a lot of time and sweat equity in exchange for being cheap to start. Itās one of the main reason I started blogging in the first place! Blogs can be started for as cheap as a few dollars a month, but they have the potential to make tons of money. Some bloggers are millionaires! What are some other businesses you could launch with high earning potential, but low start-up costs? There may be a unicorn or two in there.
Some Final Thoughts
We all have different appetites for risk, but havingĀ balance is key.
The first thing Iād highly recommend you do is:Ā find out your net worth. If you donāt know your current net worth, check out this article I wrote, and then use Personal Capital to find out where youāre at for free.
1.) If your net worth is negative: Donāt worry about investing. Worry about AGGRESSIVELY paying down your high-interest debt first. Leave low-interest debt (less than 4%) alone for now.
2.) If your net worth is positive: Awesome! Now itās time to come up with your own personal plan.. Figure out which asset classes you feel most comfortable with and start putting your cash there.Ā The younger you are, the more aggressive you can be.Ā
While you wait for your investment returns, think about things you can do in the meantime time.
All these things will help!
And remember: If youāre looking to do any activity in the high-risk high-reward quadrant, you need to first educate yourself. That arena is dominated by people with skill and knowledge.
Iāll be writing plenty more posts about that in the future, so make sure to subscribe to my email list and Iāll keep you updated when that content goes live!