Stock Investing: Risk versus Reward

In economics, “risk” refers to the likelihood that a person will lose money on an investment. An investment is the purchase of an asset for the purpose of earning money. For example, an investor buys shares of stock (units of ownership in a company) with the hope that the company will make money and the value of the stock will rise. If the stock does rise, the investor is rewarded. Stock she purchased for, say, $100 a share is now selling at $120 a share, which means that the investor could, if she wished, sell that stock for a profit. There is no guarantee, however, that the company will make money and cause the value of the stock to rise. If the value of the stock were to dip to $90 per share and the investor were to sell her shares at that point, she would have less money than when she made the investment.

It is generally true that the greater the risk a person takes, the greater the reward he or she will receive if the investment makes money. On the other hand, if an investor only takes a small risk, he or she is likely to earn a small reward. This principle is called the risk/reward trade-off. If a person buys stock in a company that has been stable for decades, such as Coca-Cola, that person assumes little risk. In other words, it is unlikely that the investor will lose money. It is also equally unlikely that the investor will make a lot of money immediately after buying the stock. If that person invests money in a less stable company, for example, a new technology firm, he or she assumes a great risk. The company could go out of business within months, in which case the investor would lose the entire value of his or her investment. The company could also make a great deal of money within a couple of months and one day develop into a major corporation. If that were to happen, the investor could become exceptionally wealthy off a small investment.

It is important to note that individual investors are not the only ones who take financial risks. Banks and other financial institutions take risks when they loan money to individuals and businesses. Likewise, insurance companies take risks when they agree to reimburse their customers in the event of a future loss.

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