April is Financial Literacy Month, and our goal is to help you raise your money IQ. In this series, we'll tackle key economic concepts -- ones that affect your everyday finances and investments -- to help you make smarter choices with every dollar decision you face.
Today's concept: risk and return.
When it comes to financial matters, we all know what risk is -- the possibility of losing your hard-earned cash. And most of us understand that a return is what you make on an investment. What many people don't understand, though, is the relationship between the two.
The relationship between risk and return is often represented by a trade-off. In general, the more risk you take on, the greater your possible return. Think of lottery tickets, for example. They involve a very high risk (of losing your money) and the possibility of an extremely high reward (the giant check with lots of zeroes). Or penny stocks: They're also very risky and yet seem full of amazing potential.
At the other end of the spectrum are options such as a savings account at your bank, or buying government bonds. They're quite low-risk, but you're not going to make a mint on them, either -- at least not these days, with interest rates so low.
Your personal risk tolerance can affect how much risk you take on, but sometimes a lack of information can get in the way and influence you, too.
Getting the Facts
Let's review the examples above.
Ironically, lotteries are presented as low-risk, high-return propositions. But they're really more like very high-risk, very low-return ones. Sure, all you have to do is shell out a few bucks for a ticket that might pay you a multimillion-dollar jackpot. But you're really much, much, much more likely to just lose all of the cost of the ticket. With the Powerball lottery, the odds of winning the jackpot are 1 in 175,223,510. Flip that around and you'll see that your odds of losing are 175,223,509 in 175,223,510 -- or, about 99.9999994 percent. And while you might win a lesser prize, overall, in the long run of buying tickets, you'll likely collect only about 60 cents or so for every dollar you spend.
Penny stocks, those trading for less than $5 or so per share, seem much more sensible than lottery tickets because they're tied to companies that are described as likely to grow in value. There's also excitement due to their low price: Being able to buy, say, 1,000 shares for just a few hundred dollars can make you feel rich. But penny stocks are often (though not always) tied to companies that have not proven themselves. Instead of track records of sales and profits, they tend to mainly offer the chance of riches, as they drill for oil or aim to cure cancer. They're also easily manipulated since there are relatively few shares of each issue. Thus, you stand a decent chance of doing worse investing in penny stocks than even with lottery tickets!
Less Risk, Lower Return
On what seems like the more sensible side of the spectrum are bank accounts and government bonds. Are they low-risk? Absolutely. But their returns are low, too.
According to Bankrate.com, the average money market account has recently been yielding about 0.5 percent, and you can collect as much as 1.2 percent on a two-year CD. That might sound slightly good, but when you factor in inflation, which tends to average close to 3 percent annually, you'll see that you're actually losing purchasing power over time with such investments. So, while you know at the end of the CD term you'll have made 1.2 percent on your investment, you also must recognize that with the the apparently low-risk investment comes the apparently high risk that you won't keep up with inflation.
In your Life
Risk and return play a part in our nonfinancial lives, as well. Think of that lovely person you'd like to date, for example. Asking him or her out involves the risk of being turned down or embarrassed. But the possible return is significant, too, if you end up in a meaningful relationship.
The principle even applies at restaurants. Take a chance on a menu item you've never tried and can't pronounce instead of your safe and boring usual order. It's riskier, but you might discover a new favorite.
When it comes to your money and the financial decisions you make, the more informed you are, the more rationally you'll be able to assess risk and return.
In many cases, you'll want to aim for the middle of the spectrum, taking on a moderate level of risk in exchange for a moderate return. You can do that by spreading your money around -- for example, including a mix of stocks and bonds in your portfolio. It's via smart asset allocation that you'll make sure not to overexpose yourself to risk while getting the best reward possible.
Learning about some simple economic concepts can make you a better financial thinker and decision maker.