Risk vs Reward: Understanding This Intricate Investing Dance

The stock market can be unpredictable and complex, so having a good grasp on how to mitigate risk is essential.

Balls with the words "risk" and "reward" sit on opposite ends of a seesaw sitting on top of a ball that says "balance."
(Image credit: Getty Images)

The world of finance is an ever-changing landscape. From rising inflation rates to the dynamics of the stock market, various challenges and opportunities present themselves and can make or break even the most carefully crafted investment strategies. Understanding the complex relationship between risk and reward becomes essential.

Risk signifies the possibility of losing part or all of one’s investment, while reward tempts investors with the promise of potential gains. Financial markets are unpredictable and can include downturns that pose challenges. Successfully navigating the unpredictability of the market requires thoughtful consideration of risk vs reward, acting as the compass guiding investors through a complex financial landscape.

Diversifying and compounding: Strategies for mitigating risk

One key strategy for managing risk in investments is diversification. By spreading investments across different asset classes, industries and regions, this will mitigate the impact of any single investment's underperformance on the overall portfolio. While diversification doesn't guarantee profits or eliminate all risks, it acts as a shield against significant losses, showcasing the wisdom of not putting all “eggs in one basket.”

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Compounding is another powerful concept that can significantly enhance long-term returns. It involves reinvesting earnings, such as dividends or capital gains, allowing investments to grow even more. Starting early and giving investments time to mature enhances the potential rewards. However, it's crucial to acknowledge that compounding is not immune to market volatility, underscoring the need for a thoughtful and measured approach.

Stocks: High rewards, higher risks

Investing in individual stocks is an avenue that offers both rewards and risks. Stocks represent ownership in a company and provide the potential for capital appreciation and dividends. The price of a stock is influenced by factors such as company performance, industry trends, economic conditions and investor sentiment. While stocks historically develop higher returns compared to other asset classes long term, they are also prone to significant volatility.

Having a comprehensive understanding of a company's business outlook, as well as the current state of the market, is imperative for knowing the risks associated with investing. Defensive stocks, for example, offer steady earnings and consistent dividends regardless of overall market performance, acting as a shield against broader economic uncertainties.

Exchange-traded funds: Diversification made accessible

Exchange-traded funds (ETFs) can be an appealing option for those seeking diversification without the complexities of individual stock selection. These investment vehicles pool investors' money to create a diversified portfolio of assets, spanning stocks, bonds or commodities. 

ETFs offer the benefits of diversification and liquidity, allowing investors to gain broad market exposure without the need to purchase individual securities. While ETFs can mitigate risk through diversification, it's essential to understand the specific fund's strategy, holdings and associated fees before investing.

Empowering the next generation

Teaching kids about risk vs reward involves using relatable, real-life examples. For instance, explaining the concept of saving money for a desired toy and earning interest at the bank illustrates the idea of delayed gratification and potential rewards over time. As kids grow older, incorporating real-world investment stories helps them grasp the realities of investing, from success stories to instances where investments didn't pan out as expected.

Discussing risk tolerance is also vital. Kids need to understand that different investments carry varying levels of risk, and aligning their choices with their risk tolerance and long-term goals is key. The concept of diversification can be introduced using relatable scenarios, illustrating how spreading investments across different "baskets" helps manage risks.

To complement these lessons, educational resources like Invstr Jr can play a pivotal role by providing interactive tools, games, and simulations designed to make finance and investing engaging for kids (I am the founder and CEO of Invstr). By exploring such platforms, young investors can gain valuable insights into risk vs reward, diversification and other fundamental investment concepts in an enjoyable and interactive manner.

The world of investing is a fascinating realm, offering both opportunities and challenges. As we empower the next generation of investors, instilling these principles early on equips them with the tools they need to make sound financial decisions and navigate the intricate dance of risk and reward in the ever-evolving landscape of investments.

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Kerim Derhalli
Founder and CEO, Invstr

Kerim Derhalli is the founder and CEO of Invstr, an award-winning financial education and investment app. Invstr’s mission is to empower everyone to take charge of their financial future. Invstr has been downloaded over 1,000,000 times by users in over 220 countries. Prior to Invstr, Derhalli built a 30-year career building, growing and managing multibillion-dollar businesses at leading financial institutions all around the world.